“Value Investing” is commonly misunderstood as buying companies at a discount to their intrinsic value. While that may have been true decades ago, today “Value Investing” predominantly consists of buying low “price to something” stocks.
Let’s begin with the basics:
Value: Monetary or material worth
Cheapness: Relatively low in cost
Finding stocks that are low in cost relative to last year’s earnings, book value or complex combination thereof (low price to something) is hunting for cheapness. From a portfolio construction perspective, cheapness has been an acceptable approach for decades, and likely will be again in the future. However, cheapness is not value.
Cheapness has existed as an investment concept forever, but it became institutionalized with the Fama/French’s 1993 three factor model. Cheapness has never been the same as hundreds of billions poured into equity investment strategies focused on buying low “price to something” stocks supported by reams of back test data. In addition, thousands of small investment professionals and amateurs replicate much of the process the large firms employ via access to abundant datasets on Yahoo! Finance and other such services.
This frenzy has culminated with “Value” or Cheapness investing failing over the last decade:
In fact, Graham and Dodd believed that true value investing involves deriving the value of a common stock independent of its market price.
True Value Investing requires specifying a firm’s expected future cash flows discounted for time and risk to determine if it is worth more or less than its current traded price.
Think about this, over the past decade, the business models of the world’s largest companies have dramatically changed. How much R&D were companies spending relative to Net Income in 1998 compared to today’s market leaders?
As technology accelerates the creation and disruption of industries and business models, accounting based relationships that worked well in a backtests settings will at best lag (a decade?) in efficacy until new formulations are specified and at worst are not robust enough (or maybe never?) to keep up.
Another example, companies will start capitalizing operating lease payments. How will current quantitative models handle such changes in leverage compared to decades of data that ignored such treatment?
It is important to always remember – Cheapness is not value.
Why should anyone think that last year’s earnings, next year’s earnings, or current book value represent the intrinsic value of a company which is the present value of ALL EXPECTED future net cash flows?
Applied Finance is a true “Value” investor, developing intrinsic value estimates by generating cash flow, and risk estimates for 20,000 global stocks weekly to determine their intrinsic value.
Therefore, it is not surprising that The Valuation 50 results have deviated significantly from cheapness strategies.
In a typical slice of the most attractive or unattractive stocks ranked on price to book vs deviations from intrinsic value, the overlap is less than 40%.
The Valuation 50 is a unique investment strategy that has performed extraordinarily well, ranking in the top 5% for Large Cap Strategies since its inception in 2004 according the Zephyr.
True Value investing hasn’t stopped working, cheapness has.
An important, but unstudied issue for practitioners and academics to understand is:
• Do cheapness strategies independently generate excess returns?
• Are cheapness strategies simply correlated to intrinsic value, which generate excess returns?
Join us in our upcoming Valuation Driven™ Webinar Series
Drawing from over 20 million real time valuations performed by Applied Finance since 1995, we explore these topics in depth.