Tap Value Investing To Improve Portfolio

Foreword from ShareInvestor

This article “Tap Value Investing To Improve Portfolio” by Teh Hooi Ling was first published in The Business Times on 13 March 2004 and is reproduced in this blog in its entirety.

In Singapore, as can be seen from the portfolios that BT tracks, value portfolios like the lowest PTB and lowest PER portfolios have significantly outperformed the analysts’ upgrades portfolio which approximates the glamour portfolio.

DMX and Raffles LaSalle vs Jurong Cement and Sincere Watch. Which would you put your money in?

Most would go for the first group, and they can be classified as growth investors. On the other hand, value investors are those who look for undervalued companies.

Let’s look at the most common metrics in valuing stocks, the price-earnings ratio (PER). The growth investor is primarily concerned with the earnings component of the ratio.

If the investor believes the company can deliver an x per cent of growth rate, and the PER is significantly less than x, he or she will buy the stock. This is even if the PER is above market average.

So if the earnings materialise and growth is expected to be sustained, the stock price will increase to maintain its PER. The key risks for the growth investor are that future growth does not occur as expected and that the PER declines as a result of, say, a change in view that the company can keep up its growth rate.

Meanwhile, the value investor is concerned with the price component of the ratio. The price has to be ‘cheap’ by some comparison.

Various measures can be used to ascertain if a stock is ‘cheap’. It could be the market price of the stock relative to the book value of the equity, or price-earnings ratio, or price-to-cash flow ratio.

The value investor’s assumption is that the ratio is too low, perhaps due to over-pessimistic assessment of the company’s future. And he or she believes that the ratio will revert to normal or market levels. The main risk here is that there is a genuine reason for the cheapness of the stock, that is, the company may eventually end up bankrupt.

Evidence Favours Value

So which investment style pays better over time?

Based on the abundance of the evidence from studies on the book-to-market effect and related anomalies, the academic community has generally come to agree that value, on average, outperforms growth investment strategies.

For example, Fama and French found that between 1963 and 1990, stocks with lowest PTB (price to book) or the value portfolio outperformed those with the highest PTB, dubbed glamour portfolio, by an average of 1.53 percentage points a month.

Many of the lowest PTB stocks were small cap stocks, so the outperformance could be due to the size effect.

Lakonishok, Shleifer and Vishny, in their 1994 study, controlled for size. They found that companies of the same size but differing in attributes such as PTB, PER and price-to-cash flow ratio had markedly different returns.

Portfolios with the lowest PTB, PER and price-to-cash flow ratio, on average, outpaced those at the other end of the spectrum by between 5.4 and 8.8 percentage points a year.

Meanwhile, Chan and Lakonishok updated the study to include the dotcom boom, that is, till 2001. And their conclusion remained the same – that there is more value in value stocks.

Their extreme value portfolio consists of ‘cheapest’ stocks captured by metrics such as PTB, PER, price-to-cash flow and price to sales ratios. Their findings were reproduced in the accompanying table.

The fact that value stocks do better than glamour stocks does not hold true only for the US market. Studies done in most other markets also exhibit similar traits.

In Singapore, as can be seen from the portfolios that BT tracks, value portfolios like the lowest PTB and lowest PER portfolios have significantly outperformed the analysts’ upgrades portfolio which approximates the glamour portfolio.

Why Value Pays

While there is consensus that value pays, the reasons why it does are still being debated.

Fama and French argued that stocks with low PTB ratios are more prone to financial distress and are hence riskier than glamour stocks. Chan and Lakonishok, however, disagreed. Going by that argument, Internet stocks which had virtually no book value but huge market value in the 1990s would be considered much less risky than traditional utility stocks.

They quoted another study to dispute the argument that value stocks are more risky. That study showed that when market return was negative, value stocks outperformed glamour stocks and the outperformance was somewhat more pronounced in the worst 25 months. And when the market earned a positive return, the value portfolio at least matched the performance of the glamour portfolio.

However, what I found in Singapore is the reverse. Here, the lowest PTB portfolios are more likely to outrun the general market in up markets, and do worse when the market is declining. This could be due to the fact that there are no utility companies in Singapore and that many of the lowest PTB stocks are loss-making and near distress.

A competing explanation for the returns on value stocks draws on behavioural considerations and agency costs.

Studies in psychology have suggested that individuals tend to extrapolate linearly. So past good performance is often projected too far into the future, thus creating favourable sentiment for glamour stocks.

A study from 1951 to 1998 found that typically, stocks fetching high prices relative to book value and earnings end up falling short of investors’ hopes. On the other hand, investors are quick to jump on the bandwagon and chase stocks with high past growth.

Meanwhile, analysts have a self-interest in recommending successful stocks to generate trading commissions and investment banking business. Moreover, growth stocks are usually in ‘sexy’ industries and are thus easier to tout when it comes to analyst reports and media coverage. As for fund managers, most wouldn’t want to be caught dead holding companies with tainted past performance. Even if they want to, the poor liquidity of many of these stocks may deter big funds from buying into these value stocks.

The result of all the above is that value stocks become underpriced and glamour stocks overpriced relative to their fundamentals.

What to do?

Human nature is such that we don’t want to miss out on the next big thing. Indeed, if you managed to catch them early, some growth stocks can yield fantastic returns. And who can deny the ego-boosting high of being able to brag to your friends that you have Datacraft and Chartered Semiconductor in your portfolio during the dotcom mania?

Well, by all means buy some growth stocks for your portfolio. The thing is not to have your entire portfolio made up of glamour stocks – that’s a sure ticket to heartache.

As a small individual investor, you are better positioned to exploit the inefficiencies in the market. So include some of the value stocks in your portfolio: those with very low PER, those whose shares are trading way below the value of their relatively decent assets, or those which have been making losses but are showing signs of turning around.

Not only do these stocks have low correlations with the broad market which will reduce the wild swings of your portfolio value, they most likely will also add handsomely to your overall returns.