Value investing is the strategy of purchasing an asset which is trading at a significant discount from its determined intrinsic value. It has long been regarded as a low risk method of providing outstanding investment returns (Klarman 2001). The investment strategy was described by Benjamin Graham and David Dodd in their book, Security Analysis (1940, p. 724). Over subsequent decades the investment approach has evolved utilizing varying fundamental methodologies but always maintaining the principle of investing when a discount to intrinsic value exists. Graham and Dodd (1940, p. 368) referred to this principle as the 'margin of safety'. This essay will explore the various methodologies, expand on the 'margin of safety' concept and discover the factors that have led to the success of the exponents of value investing.

Bierig’s (2000) assessment of the Graham and Dodd approach indicated that a value investor doesn’t just follow share market fads but instead ‘searches for stocks selling for less than their intrinsic value’ and after purchasing, waits for market recognition that corrects this discrepancy. Athanassakos (2011b) has illustrated that a search for undervalued stocks is the initial process undertaken. He maintains that these stocks tend to be ‘avoided by large institutional investors’ and are not the ‘glamour stocks everyone wants to own’. Graham (1973, p. 211) describes two methods of searching for fundamentally undervalued stocks; companies selling at a low price to earnings ratio (PER) and companies selling under their net current asset value, otherwise known as a low price to book value (P/BV). Companies matching these criteria are widely described as value stocks (Athanassakos 2011b; Basu 1977; Fama & French 1992; Lakonishok, Shleifer & Vishny 1994; La Porta et al. 1997). There is extensive academic research documenting that value stocks produce higher average returns than growth (high PER or P/BV) stocks, which is referred to as a 'value premium' (Athanassakos 2011a).

Graham and Dodd (1940, p. 530) pioneered the use of the PER as a gauge of value. They revealed that 'a common stock is generally considered to be worth a certain number of times its current earnings', adding that an investor should take the 'average earnings of a period between five and ten years' and then ‘not pay more than 20 times those average earnings’.

According to Dubinsky (2006), early studies examined low PER stocks, confirming their outperformance but the time series used lacked statistical strength. Using 14 years of data, Basu (1977) was the first to comprehensively study a low PER investment strategy also finding that it provided 'superior returns'. Trevino & Robertson (2002) have also confirmed higher average returns are generally provided by low PER stocks than by high PER stocks. Research into low PER stocks by Dreman and Berry (1995) offered reasoning to why the outperformance occurred; low PER stocks tend to be mispriced due to over pessimism. Simply, as these stocks have performed poorly in the past, they become oversold, ‘out of favour’ and often underpriced. They theorized that an 'event trigger' like a positive earnings surprise leads to a mispricing correction and the resultant outperformance.

As with low PER stocks, the methodology followed by value investors of buying companies selling under their net current asset value or a low P/BV have also been shown to outperform the market (La Porta et al. 1997). In various studies Fama and French (1992, 1993, 1998, 2005) have also confirmed the value premium exists for low P/BV stocks. Although they contend that this strategy results in increased risk being borne by the investor because of the highly distressed state these firms tend to be in. To counter this higher risk, Graham (1973, p. 216) advocated the purchase of a diversified group of low P/BV firms that had made a profit in the preceding 12 months. He also advised ‘don’t lose patience’, because it may take considerable time before profits materialize from a low P/BV approach.

Lakonishok, Shleifer & Vishny (1994) investigated low P/BV returns along with that of other value strategies. Focussing on portfolio returns over time horizons of up to 5 years, the researchers offered strong empirical evidence of the effectiveness of the low P/BV strategy. Specifically average annual returns of 19.8% were reported. They were also able to surmise that there is ‘no support for the hypothesis' that value strategies are fundamentally riskier. Piotroski (2000) expanded on research into a low P/BV strategy by only choosing financially strong firms using nine fundamental financial signals. This refined investment strategy was shown to generate returns above value portfolios formed solely by the low P/BV screening method. He then improved on this approach by demonstrating a strategy of short selling the financially weaker low P/BV firms to produce over-all returns of 23% per annum. Piotroski also notes that initial signs of improvement in financial performance are at first ignored by market participants, with share price reactions only occurring during subsequent positive quarterly earnings announcements.
Investors and analysts have a tendency to rely too heavily on the record of past earnings growth (La Porta et al. 1997). According to Lakonishok, Shleifer & Vishny (1994) popular strategies like 'extrapolating past earnings growth too far into the future' or 'assuming a trend in stock prices', 'overreacting to good or bad news', or 'simply equating a good investment with a well-run company irrespective of price', inevitably leads to mispricing.

Previous research by Durand (1957) identified that when the growth record of a stock is recognized, the price tends to advance beyond that of its low growth counterparts, so that its’ PER departs from what is considered a ‘conventional standard’. Dreman and Berry (1995) refer to this as a price 'overreaction' where the distinction between growth and lack of growth is no longer obvious. The ‘exaggerated optimism’ in the market price now discounts the growth potential. This 'overreaction' has been shown to be the main reason for growth stocks underperformance compared to value stocks in numerous studies (Basu 1977; De Bondt & Thaler 1985; Dreman and Berry 1995; Fama & French 1992; Lakonishok et al. 1994; La Porta et al. 1997).

Value investor’s success comes from being ‘contrarian’ to popular strategies followed by other investors (Chan, 1988). They are ‘contrarian’ because they over invest in under-priced ‘out of favour’ stocks and under invest in over-priced ‘in favour’ stocks (Lakonishok et al. 1994). Buying losers and selling winners produces positives results refuting the theory that stocks take a random and unpredictable path (Lehman 1990; Lo & MacKinlay 1990).

Warren Buffet, the most renowned exponent of the value investing approach (Bierig 2000; Statman & Shied 2002), discussed the success of fellow 'value investors' in his ‘Superinvestors’ speech (Buffett 1984). In it he examined the investment performances of followers of a Graham and Dodd approach over many years. His conclusion is identical to the academic research, in that value investing is successful over the long run. Buffett posed that these investors ‘look for value with a significant margin of safety relative to price’. They are successful because they not only screen for the value stocks but also ascertain an intrinsic value and buy with a ‘margin of safety’.

Recently Athanassakos (2011a) investigated and confirmed the value premium in a study conducted on Canadian markets between 1985-1999 and 1999-2007. Value and growth stocks were classified by means of standard methodologies used in previous academic studies. This study further explored valuation techniques that identified which of the value stocks possessed a ‘margin of safety’. These truly undervalued stocks qualified for a ‘sophisticated’ portfolio. A 'naive' portfolio was formed for the remaining value stocks not meeting these measures. The 'sophisticated' portfolio was shown to outperform the 'naive' portfolio over the period mentioned. The research also looked at returns during the recent Global Financial Crises (GFC), specifically during the period of May 1, 2008 to April 30, 2009. The ‘sophisticated’ portfolio outperformed both the 'naive' value and growth portfolios, on average, over this period. Value investors are said to ‘add value’ because they weigh up the value and apply a ‘margin of safety’, confirming Buffets earlier observations of the ‘Superinvestors’.

Additionally Fama & French (1998) have identified the existence of a value premium in thirteen major equity markets around the world including the Australian market. Nguyen, Faff & Gharghori (2009) recently followed up this research, also confirming the value premium in Australia. Furthermore Beukes (2011) has also shown South African markets possess a value premium. Over recent decades value orientated asset management firms have established in Australia. Two such firms, with over 15 years of operation, Platinum Asset Management (2011) and Hunter Hall Investment Management (2011b) have produced returns substantially exceeding market averages during this extended period. The Hunter Hall (2011a) value growth investment strategy identifies quality stocks with good long term growth potential and then buys the stocks at prices that are substantially less than their intrinsic value.

In conclusion, the success of value investing comes from purchasing undervalued assets with a ‘margin of safety’. It's a 'contrarian' strategy that shuns market fads and buys out of favour stocks. Benjamin Graham (1973) counselled patience and explained that 'in the short run, the market is like a voting machine' - overreacting to the popular and unpopular stocks but 'in the long run, the market is like a weighing machine' - correcting the mispricing that can occur. That is, over time, undervalued assets tend to become more accurately valued by the market. The evidence is in the enduring track record of the exponents of value investing.

References

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Why have the exponents of value investing been so successful?