Equity investing generally is grouped into one of two styles--growth or value. (Some investors do buy stocks for income, but that strategy is not covered in this article.) Growth stock investors focus on companies expected to sustain above-average earnings increases. This style often involves paying a high price relative to current earnings or book value under the assumption projected earnings growth will be sufficient to justify that price.
In contrast, value investors first ask what a company is worth today--without assuming substantial growth or changes in the business. They then try to buy a stock when it is selling at a substantial discount off its intrinsic worth (often characterized as buying at "fifty cents on the dollar"). By so doing, value investors create a margin of safety that growth investors typically do not have. One example is Sears, which sold for $37 per share in 1992 and had a 5% yield. However, the value of the company's nonretail subsidiaries--Allstate, Dean Witter and Coldwell Banker--was between $50 and $75 per share of Sears. Since 1992, Sears has sold or spun off those divisions, creating a market value of about $100 per original share of Sears.
WHY VALUE INVESTING?
Both philosophies have advocates. Although there are successful followers of each, empirical research appears to favor value investors. Why? To start, the underlying premise of growth investing is that an investor can accurately predict both earnings and earnings growth. Unfortunately, forecasting earnings is extremely difficult, even for professionals. In October 1994, research published in Forbes showed security analysts' forecasts for the current year's earnings were off by an average of more than 40%. Moreover, 75% of all earnings estimates missed actual reported earnings by 30% or more.
Given the highly unreliable track record of analysts' near-term earnings projections, why expect them to be any more accurate in forecasting long-term growth rates? Thus, "paying up" for projected growth would appear less than prudent. Although there are companies that can grow substantially over time, it is difficult for investors to consistently identify and profit from them. Indeed, the worst stock price casualties seem to occur when high-price growth companies disappoint investors with lower-than-anticipated earnings. With little margin of safety, there often is a steep and painful stock price drop.
Benjamin Graham, widely considered the father of value investing, showed in a 1976 research study that applying value investment principles resulted in an annual rate of return of approximately 19% over the 50-year period from 1925 to 1975--well above the general market. More recent studies show the value approach has outperformed both the Standard & Poor's 500 and growth stocks over the past quarter century while at the same time incurring lower risk.
Furthermore, value strategies did better than growth strategies in recessions when investors may well be more risk-averse. And in the 25 worst months for U.S. stock markets, value stocks fared better than growth stocks every time. The margin of safety concept goes hand-in-hand with the strong emphasis value investing places on capital preservation. Simply stated, the first rule of making money is not to lose it. An investor who loses 50% in one year must earn 100% in the next just to get even. Thus, eliminating large losses enhances the probability of better long-term results.
Once an investor joins the value school of investing, what factors should be sought in any particular investment? Here are eight criteria investors should consider. Those choosing a value-oriented mutual fund instead of individual stocks should try to understand how a fund manager applies these principles by reading the fund's prospectus as well as recent quarterly reports.
1. Price-to-earnings (P/E) ratio. While the general stock market P/E ratio (price divided by earnings per share) typically is between 14 and 18, disciplined value investors favor stocks with P/E ratios at significant discounts to the market's.
2. Price-to-cash flow ratio. Using cash flow rather than reported earnings helps eliminate accounting distortions from items such as depreciation and goodwill. Consequently, some value investors give equal or perhaps more weight to this ratio.
3. Price-to-book value ratio. As of December 1995, the S&P 500 was selling near 3.5 times book value, a historic high. Value investors would be more partial to stocks selling closer to book value.
4. Dividend yield. Growth investors rarely pay much attention to dividends. However, research by Ibbotson Associates has shown that since 1925, approximately half of the total annual 10% return for the stock market has come from dividends. As of December 1995, the 2.3% S&P 500 dividend yield was the lowest on record. Value investors in the current market generally would like yields on individual stocks to be above 3%, assuming a company is financially able to maintain the dividend.
5. Private market value. This is an estimate of a business's value if it were acquired or merged. The best gauge is to look at sales of comparable companies. Value investors will buy a stock flit can be purchased for less than 50% to 60% of the estimated private market value.
6. "Adjusted net" working capital. Stocks occasionally trade below adjusted net working capital per share (current assets less current liabilities and long-term debt divided by shares outstanding). This represents an estimate of the asset's cash liquidation value, excluding property, plant and equipment. Value investors buy stocks at two-thirds or less of net working capital on the premise that if the market does not eventually push the stock price up, a third party will come in, force a liquidation and profit from the discrepancy between the stock price and the "cash" value.
7. Insider buying. While not confined to value investors, insider buying often is a strong signal of value. Meaningful insider purchases (which are a matter of public record) often indicate management's bullishness. Conversely, insider sales can signify that difficulties lie ahead. It is important to distinguish, however, when such purchases or sales relate to extraneous factors, such as the insider's stock options or personal liquidity issues.
8. Stock repurchases. Like insider buying, company announcements of stock repurchases demonstrate that management views its stock as a good investment. Recent research shows investors generally experience above-average returns after company stock buybacks. On the other hand, companies with recent secondary stock issues or initial public offerings tend to experience below-average returns. Consequently, value investors often shy away from these companies.
It is unlikely all of the above criteria will be met on a significant number of stocks. However, consistently applying these principles can provide some rewarding long-term results. We demonstrated this when we systematically screened a wide universe of stocks to find companies that met several financial criteria measuring market capitalization and their ability to maintain their dividends over the last 10 years. The 10 stocks with the highest dividend yields were assumed to be held in a portfolio for six months, and then the entire process was repeated every six months. This consistent application of the dividend criteria produced annualized returns near 21% from 1986 through 1995 (as compared with 14.7% for the S&P 500).
Value investing delivers superior returns over long periods with less risk than growth stock investing. Despite the obvious success of value investing, few investors consistently use the approach in the stock market. Why? Value investing requires both going against the crowd and being very patient. Such traits are rare among either individual or institutional investors, who are focused primarily on short-term achieving results. CPAs with clients who can be patient may find it quite rewarding to recommend a value philosophy.
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* EQUITY INVESTING CAN GENERALLY be grouped into two styles, growth or value. Growth investors focus on companies expected to sustain above-average earnings increases. Value investors concentrate on what a company is worth today, without assuming any substantial growth or change.
* EMPIRICAL RESEARCH APPEARS TO FAVOR value investors. The inexact science of forecasting makes it difficult for investors to identify and profit from growth companies.
* AN INVESTOR WHO IS WILLING TO follow the value school of investing should consider eight factors in selecting securities (or mutual funds), including price-to-earnings ratio, price-to-cash flow ratio, price-to-book value ratio, dividend yield, private market value, adjusted net working capital, insider buying and stock repurchases.
* CONSISTENTLY APPLYING VALUE investing principles can provide rewarding long-term results. From 1986 through 1995, the annualized returns were near 21%, as compared with 14.7% for the Standard & Poor's 500.
MARVIN I. KLINE, CFA, and RICHARD E. BUCHWALD, CFA, are the senior officers of Berwind Investment Management, Philadelphia.
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|Author:||Buchwald, Richard E.|
|Publication:||Journal of Accountancy|
|Date:||Apr 1, 1996|
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