The Case for Value Investing

Value investing, the practice of buying stocks that appear underpriced and holding them until the market realizes their true worth, can be a successful strategy even in the current market. Here's what you need to know.

Many investors are asking whether "value" stocks still represent good value for one's investment dollar, and if so, under what conditions value stocks can be expected to generate good performance. They also want to know to what extent classic methods of value investing need to be adapted to the current, puzzling market environment.

One current argument in favor of value is that growth-stock indices currently sell at much higher multiples (e.g., price/earnings ratios) than value-stock indices. If these multiples revert toward a more normal relationship, it is argued, market leadership will shift in favor of value. The current case for value investing cannot, however, be established by relying on mean reversion--or else value would have started outperforming growth long ago. We must demonstrate that selected value companies represent good value in the sense of having a fundamental worth substantially higher than the current market price.

Sponsors should look at the recent declines in value indices and actively managed portfolios as an opportunity to take advantage of a potentially historic trend reversal. Such a strategy is not without risk, because the tendency of investors to put money into the most recent high-returning strategies can make trends, such as the current preference for growth, last longer and go farther than can be justified by fundamentals. Actively managed portfolios can benefit from some retooling of the value process and perhaps earn returns better than those of the benchmark, and with less risk. In the long run, the prices of financial assets must necessarily converge on their fundamental values. Value investing is the only discipline that takes full advantage of this timeless principle.

Is Value Junk?

The disfavor into which value stocks have fallen reflects a change in perception. In the 1980s, value stocks were widely regarded as good companies that were unloved by the market and that were merely waiting for a takeover or other catalyst that would cause the market to realize their true, much higher value.

Today, the perception is that many value issues are considered to be junk stocks, representing sunset industries, low margins, bad balance sheets, and poor management.

Growth, at this time, is associated not only with rapidly growing earnings but with low risk, high earnings quality or acyclicality, progressive management, and everything else good and beautiful. This set of perceptions creates some opportunity for value investors, since it has knocked down the prices of good companies along with the bad.

But there may really be some junk in the value sector: many deep-value managers have been torpedoed by earnings disappointments and other bad news, driving their returns well below that of the benchmark. In this market, naive value screening doesn't seem to work, and portfolio choices must be subjected to careful fundamental analysis.

Investors have to sell something to get the money to make purchases. Since many investors sell their poorest performers, they have tended to dump value stocks (especially deep value stocks), accelerating these stocks' decline and sending them into something like a free fall. This trend has been exacerbated by the tax-motivated desire to realize losses to offset big gains in growth issues. Whenever a technical factor is powerful enough to cause a substantial price move in a category of securities, it creates an opportunity for bettors against the trend--as long as they have the patience and the capital to withstand further procyclical movement.

Value Over Growth

The traditional case for value investing rests on two points. First, there is some evidence that value beats growth in the very long run, especially after adjusting for the greater risk (volatility) of growth stocks. And second, value stocks are especially timely now that growth-stock prices are overextended.

The traditional evidence cited for the value effect is the outperformance of value indices since the starting point of widely available style index data in 1975. But the growth run of the last few years has caused this cumulative outperformance to shrink almost to the vanishing point. Timing would have been necessary to achieve a decent return from value because the swings of value versus growth are both wide and long-lasting.

But Eugene F. Fama and Kenneth R. French, backdating their renowned work on the three-factor model (beta, size, and book-to-price), have constructed style indices back to 1926 and find that value very decisively outperformed growth when measured over that period, which includes numerous episodes of inflation and deflation, boom and bust, and technological change and stability.

This study bolsters the contention, now widely doubted by investors, that value provides superior (or at least competitive) returns in the very long run.

While studies of value that depend on more recent (1975 to the present) data emphasize the need for declining interest rates or economic recovery for value to perform well, the Fama and French study shows that value stocks added much of their historically superior performance during the best years of the postwar expansion. Much of that period was characterized by rapid economic growth, the emergence of new industries, low unemployment, and low inflation. Some of these conditions are echoed in the current economy, although monetary policy was easier over much of that period than it is today.

While value stocks (having lower earnings growth rates, weaker balance sheets, and less liquidity) would appear on their face to be riskier than growth stocks, value indices, reflecting the diversification inherent in holding many positions, have statistically less risky returns than growth indices.

This can be supported by some intuition. At times like the present, the valuations of growth stocks tend to be over-inflated, making them vulnerable to even small earnings disappointments and other kinds of bad news, and giving them a lot of downside risk. Value stocks, when beaten down as they are now, are volatile but the possibility of further large downside movements is limited by breakup value and even cash value.

When Has Value Outperformed?

Declining interest rates tend to help value stocks more than growth stocks because highly indebted (value) companies can refinance their substantial debt burdens at lower rates; growth companies typically do not have these burdens and do not get this direct benefit of lower interest rates. Some analysts have argued the contrary: that growth stocks should benefit more from declining interest rates because growth stocks have a longer duration. But in most declining interest-rate environments, except for the brief and bizarre 1998 episode when Treasury yields plummeted in a "flight to quality," the leverage effect has trumped the duration effect and value has outperformed.

Cyclicality of earnings is helped by recovery from an economic recession. Corporate earnings are a leveraged bet on GDP growth, and during recessions they fall by a large multiple of the GDP decline. In recoveries, earnings soar. This effect is much more pronounced for value than for growth stocks (in part because of the financial and operating leverage referred to above, but also because of cyclical changes in demand for the company's products). This is one reason why many value stocks are also cyclicals. Recovery-related value rallies occurred in 1975-76, 1983-84, after the crash of 1987, and in 1992-93. Later in the economic expansion, growth stocks outperformed. Note that recovery from an industry-specific recession can be just as helpful to the value stocks in that industry as recovery from a general recession.

High operating leverage causes a company to be helped by increased demand for its products and services, making the company cyclical. But if fixed costs are insensitive to inflation, then high operating leverage may cause a company to be helped by increased pricing power. For most value companies, the inflation benefit from operating leverage is minor, but in a few businesses it is dominant. It costs roughly the same, for example, to grow an acre of wheat or mine an ounce of gold whether the price received is high or low. For such companies, which are typically value companies, inflation in the commodity they sell is a tremendous boost to earnings and the stock price.

Inefficient management causes companies to become takeover candidates. In a takeover, the new owners often force out the inefficient management and cut costs, to the delight of investors who then push the stock price up. Merely being a promising takeover candidate, however, does not cause the takeover to happen. It helps if the stock market is richly valued and capital costs are low, so that the acquirer can borrow or offer a strong currency, in the form of its stock, to the acquiree.

Adapting the Value Style

The classic value approach--buying stocks that are low-priced compared with earnings, cash flows, book value, or dividends--needs to be retooled a bit.

Fundamental, company-focused research is the only way to determine the presence or absence of catalysts in a value story. The value process must include such research rather than relying on statistical indicators of underpricing. Don't rely on buyouts. While strategic buyers of value companies have been active, financial buyers are scarcer; some private-equity firms that were traditionally focused on buyouts are trying to get in on Internet deals instead. Thus, the value investor should not assume that the hoped-for repricing will be achieved through a buyout. Careful analysis of the potential buyers for a value company may reveal positive or negative information about the likelihood of such a transaction.

Several researchers have noted that the value effect is more powerful, and that it works over a larger proportion of historical time, if one compares underpriced with overpriced companies in the same industries. One possible reason is that value metrics, such as earnings and book value, are not closely comparable across industries because of differences in the way depreciation, amortization, and other accounting variables are treated. A portfolio that takes advantage of this insight could conceivably have market weights in the various industrial sectors, holding the companies within each sector that represent the best value. In practice, most value managers will continue to overemphasize certain industries associated with value, but not to the extent that would occur if one compared the valuations of all companies without regard to what industry they are in.

Some stocks appear to be, but are not, good values because the companies are likely to experience earnings declines, lose money, or go out of business. Such companies are often in industries in which there is declining demand for the product, foreign companies are becoming the low-cost providers (such as steel), or some other unfavorable change in fundamentals is taking place. When looked at using only statistical tools, these companies appear cheap. Fundamental analysis (including economic and competitive-market analysis), again, is the only discipline that will identify sunset companies and industries and enable the value investor to distinguish pearls from junk in a turbulent era when many industries may be experiencing their sunset years.

Because large moves in groups of stocks can occur for purely technical reasons, momentum and funds flow analysis should be incorporated into the value process--just as these tools are used by growth investors. One such recent technical effect is the steepening of the rate of decline in some widely held deep-value stocks because of value-fund redemptions, unrelated to any news or change in fundamentals. The value-fund redemptions are, in turn, due to poor performance of these funds in immediately prior periods. Other technical effects come from style-index reconstructions. A portfolio manager who can trade ahead of these kinds of effects may outperform, although this is difficult to do with large portfolios.

The construction of some style indices encourages some value managers to perform their initial screens for value stocks naively, using simple ratios such as P/E and price-to-book-value. What makes sense for index constructors may not make sense for portfolio managers. Index constructors need rules for choosing value stocks that are well-defined, easily communicated in advance, and efficient to implement. Active portfolio managers need to develop additional insight to beat, not match, the indices constructed according to simple rules.

John Alexander is a portfolio manager with Invesco Inc. in Atlanta. Laurence Siegel is director of investment policy research at The Ford Foundation in New York.

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