The more risk you take, the more return you should expect to earn in the long-term. This is the reason why value stock investing has been popular since the New York Stock Exchange opened its doors in 1792. Value investing involves the study of financial data to determine appropriate company valuation and then investing in the companies that appear to be a good value. Over time, companies that have low prices compared to their fundamentals tend to outperform companies that have high price ratios.
There are many different schools of thought regarding what a value stock is. Some consider value companies to have a low price-to-earnings ratio (P/E) while others use low price-to-cash flow (P/CF), book value to market value (BtM) or dividend yield. They all work to some degree, although it can be argued that some work better than others. The table below was derived from U.S. Research Returns Data from the Ken French Data Library at Dartmouth. It shows how various value strategies have outperformed the market over the decades.
| E/P | BtM | CF/P | Div/P | |
| 1950s | 8.5% | 2.8% | 5.3% | 0.5% |
| 1960s | 6.6% | 3.9% | 4.4% | 1.6% |
| 1970s | 5.8% | 7.8% | 6.4% | 4.0% |
| 1980s | 2.1% | 3.9% | 2.9% | 3.4% |
| 1990s | -0.9% | -3.3% | -2.3% | -4.4% |
| 2000s | 8.1% | 6.3% | 7.7% | 5.9% |
| Average | 5.0% | 3.6% | 4.1% | 1.9% |
As this chart shows, value investing is not new. It’s been a popular investment strategy for more than a century. John Burr Williams was one of the early pioneers of the strategy and one of the first economists to estimate stock prices by their intrinsic value. Best known for his 1938 text The Theory of Investment Value, Williams was the first to document a theory of cash-flow valuation using dividend payments.
Benjamin Graham, another pioneer, is considered by many to be the father of modern day value investing. Graham began teaching his theories at Columbia Business School in 1928 and subsequently refined this application with David Dodd through their famous book Security Analysis. Graham’s most famous and successful student, Warren Buffett, credits Graham’s investment methodology for much of Berkshire Hathaway, Inc.’s investment success.
It wasn’t until the late 1970s, however that researchers began to analyze value investing from a broad market perspective to isolate the premium paid in the marketplace for stocks that exhibited certain fundamental characteristics.
The first research report to suggest that the excess return from value stocks was payment for added risk was published in 1977. Sanjoy Basu tested the notion that value factors explained differences in portfolio returns that were unrelated to market risk. He found a positive and consistent relationship existed between earnings-to-price ratios (E/P) and portfolio returns that could not be explained by market risk alone.
Over time, several academics confirmed and extended Basu’s findings. They reported significant positive relationships between portfolio returns, price and fundamental variables. Stocks with high fundamental value relative to price (value stocks) outperformed stocks with low fundamental value relative to price (growth stocks) by a considerable amount over the long-term.
In 1992, Eugene Fama and Ken French released groundbreaking research that among other things measured book value to market price (BtM) returns for highest BtM (or value) stocks compared to the lowest BtM (or growth) stocks from 1963 to 1990. They found excess returns from value stocks over growth stocks to be more than 5.0 percent per year.
The value effect in its many forms has been documented across every global securities exchange, although different methods generated different returns in different countries. Some of these differences may have been caused by tax policy while others may have been caused by different financial reporting standards.
There is great value in value stock investing, but I caution you to think of it as a free lunch. It’s not. Researchers still don’t know exactly what causes the value premium in every market, but they do believe it’s a payment for taking extra risk above the cap weighted market. Higher risk is the reason value funds have outperformed in the past and are expected to outperform in the future.
My firm, Portfolio Solutions, overweighs portfolios to value stocks. The value tilt is applied across the global spectrum in U.S. equities, international developed markets and emerging markets. This tilt is accomplished using value stock index funds and funds that combine small cap stocks and value stocks.
We believe a value tilt will add one percent per year to a portfolio’s equity return over time. This excess return won’t happen every calendar year or even every decade. It should be applied as a long-term strategy that will pay dividends during your lifetime, pardon the pun.
