Value the sector not the stock
December 7, 2009
PORTFOLIO POINT: Companies undervalued by the market can reward investors, but they can also trap the unwary.
The forecasting season is in full swing about this time of year. The economic "sages" hold a finger aloft and pontificate on what the next 12 months might hold. Some forecasters - including analysts from Citigroup and Macquarie Bank - are suggesting accumulated returns of 20% plus from investing in shares in the year ahead.
Investors might equally intrigued by the fact that high-quality research into how investment markets work suggests that "value" companies outperform the average market return by 3% and more per year across sharemarkets around the world.
That may not sound as alluring as 20%, but on close examination you'll find it a very persuasive statistic - and of course if you believe the market will do 20% then it follows that value companies will do even better.
Either way, the fact is that in the 12 months to December 3 the ASX 200 has returned 34%.
The return from the 30% of the market with value characteristics has been 40.6% over this period as measured by the passive Dimensional Australian Value Trust (one of the many index-style funds I recommend as an adviser and hold myself).
Value investing is a significant part of the investment landscape, with many investment managers and individual investors seeking "undervalued" companies to invest in (for more on value investing see Roger Montgomery's ValueLine column every Wednesday).
However, much of the scientific/academic research around value companies suggest the returns are not so much from 'stockpicking' as from investing in the parts of the stockmarket with value investment characteristics that may be out of favour. For example, banks were very much out of favour earlier this year though they have turned out to be very rewarding over the course of the calendar year.
One of the fathers of value investing is Benjamin Graham, an academic and author of the iconic investment books The Intelligent Investor and Security Analysis (see Back to basics, a Graham and Dodd primer). In an interview in the 1970s Graham talked about how he was "no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities". This was a big statement from someone who came up with much of the thinking on "value" investing. So, perhaps including value companies in a portfolio is more than just finding value companies through analysis, after all.
Incidentally, in the same interview Graham made some broader comments on people in the financial services industry, saying they "spend a large part of their time trying, valiantly and ineffectively, to do things they can't do well". An example was trying "to forecast short- and long-term changes in the economy, and in the price level of common stocks".
So the question is: What makes a value company?
The earliest research I have seen on what we might consider value companies dates from the 1960s. It compared the returns from companies with high and low price/earnings (P/E) multiples and found that companies with low P/Es had a higher return.
Companies with low P/Es are often considered to be value companies: effectively you pay less for every dollar of company earnings - hence the value definition. Companies with high dividends, in which the investor pays less for every dollar of income they receive, are also considered to be 'value' companies.
However, academic research has tended to focus on the price-to-book ratio: the relationship between the value of the share price and the book value of company assets.
Value companies are those companies where investors pay less for every dollar of book value. The reason for the preference for price-to-book value as the ratio to identify such companies is that this is more stable over time than company earnings or dividends - which can vary significantly from year to year.
The key academic/scientific paper that supports this definition of value companies is the paper by Eugene Fama and Kenneth French, The Cross Section of Expected Stock Returns, published in the Journal of Finance in 1992.
Their research found that those companies with a lower price-to-book ratio had higher future investment returns. These were characterised as value companies. They also found that small companies had higher expected returns - and in the Australian environment we have observed a significant small-company effect over time, whereby small companies have outperformed large companies.
A key question with value companies is: Are these higher returns from investing in value companies a risk-free source of extra returns? The answer would appear to be no. A great example of value companies outperforming in recent times would be bank shares. After the extraordinary quarterly loss announced by AIG in March this year, many observers feared the architecture of the entire financial system was suspect and finance companies including Australian banks began trading at very low prices.
Based on value metrics these were value companies, however they were value companies for a good reason: they were risky companies selling at a price that reflected their risk. As these risks have unwound, so the price of banks has risen faster than the rest of the market.
Another insight into this potential riskiness of value companies is in a paper by Michelle Clayton, Excellence Revisited, published in the Financial Analysts Journal. It suggests it was not necessarily the excellent companies that made great investments, but value-style companies with "reasonable" multiples.
In one of her previous studies, Clayton categorised companies as "excellent" and "unexcellent", based on financial ratios such as profit growth and debt levels, and found that the unexcellent companies provided a better return for investors.
The value trap
One comment that should be made with any discussion of value investing is that of the "value trap", that sometimes when a company looks cheap it is on the way to failure.
Think about ABC Learning, MFS or Babcock & Brown; all were touted as value companies when they were actually heading for trouble. This also fits into the picture of value companies not being cheap but rather under financial pressure. Generally they recover and seem to provide investors with above market average returns, sometimes they fail.
The ultimate aim of many investors is to find a company that is undervalued by the market, although Ben Graham moved toward the opinion that investment analysis was likely to provide above-average returns.
Value investing, however, still has a weight of evidence that supports buying value companies leading to higher long-term returns: buying companies under financial pressure leads to higher expected returns. But the bottom line is that risk and return seem to be related even when investing in value companies.