Imagine you’re in the market for a new home.
You find two 3,000-square-foot houses, built by the same builder on the same block:
In the example above, you’d want to buy House 1, right? (Stick with me — I’ll show you what home shoppers have in common with Warren Buffett.)
You’d say, “House 1 is a better value.”
You know that because when you divide the price you pay by “what you get” for that price.
I have good news: If that makes sense to you, you can apply it to stocks.
You can perform as well as the Oracle of Omaha himself.
Warren Buffett the Value Investor
Buffett is arguably the most recognizable, revered and quoted stock market investor of all time.
People know him as a “value investor.”
And because of Buffett, what we think of as “value investing” is one of the most recognized investment strategies.
But what if I told you that the “Value factor”— which we can reduce to an algorithm, requiring no human interaction — can almost fully explain Buffett’s investment performance … essentially wiping out the story of his special Midas touch?
With a more optimistic spin…
What if I told you that you could perform just as well as Buffett if you simply use the Value factor when selecting stocks?
Buy “Cheap” Stocks
Hundreds of academic studies have shown that you can earn market-beating returns if you simply buy stocks that are priced “cheaply” and avoid buying “expensive” stocks.
A word of caution: Novice investors often view stocks as expensive based on their share price alone — so they buy four shares of a stock that trades for $5 per share rather than one share of a $20 stock.
We can use the Value factor to see why that stock is only $5, and what kind of returns we can expect going forward.
We can also determine what stocks are “cheap” and “expensive” using simple ratios, including:
- Price-to-earnings ratio.
- Price-to-book ratio.
- Price-to-sales ratio.
- Price-to-cash flow ratio.
Price-to-earnings (aka P/E) is the most popular, but all four have proven to help identify cheap stocks that are likely to outperform expensive ones.
The “price” portion of each ratio is where the share price comes in.
But the second part is what matters most to value investors: It’s what you get once you own the shares.
Example: P/E Ratio
I’ll share a simple example.
Stock ABC sells for $20 per share. ABC has produced earnings of $4 per share over the prior 12 months.
ABC’s stock has a price-to-earnings ratio of 5. ($20 price divided by $4 earnings equals 5.)
Here’s your key to understanding value: If the ratio presents the price portion first (i.e., “price-to-earnings,)” we want to buy a stock with a lower ratio.
That indicates it’s “cheaper,” or a “better value,” than a stock with a higher ratio.
Let’s revisit our house shopping example.
It’s equally important to know what you’re getting for the price you pay.
I suggested you’re getting the exact same 3,000-square-foot house. But it’s rarely that simple.
Maybe one house is constructed of wood and the other brick.
Perhaps one was built in the 1950s while the other was built in the last 20 years.
What if one has a pool, and the other doesn’t?
Stocks are similar. When you decide whether to buy Stock A or Stock B … it’s not always easy to see what you’ll get from each company.
That’s the value of our Green Zone Ratings system. It rates stocks based on six factors, including Value.
You can look at the Quality and Growth factors to have a clearer understanding of what you’re getting. (Like knowing whether you want a home with a pool, a split-level or a ranch.)
For instance, take a look at two well-known stocks’ Green Zone Ratings — Tesla Inc. (Nasdaq: TSLA) and Facebook Inc. (Nasdaq: FB).
Note that both rate in the lowest 30% of stocks on Value.
But similar to our House 1 and House 2 example … the companies’ Green Zone Ratings give us a clearer picture of what we’re getting if we buy these two stocks. (As my colleague Charles Sizemore often reminds us: “Companies that rate highly on Quality frequently get a poor Value rating, as investors pay up to get the best.”)
It’s easy to reduce Buffett’s M.O. to “value,” or “buying companies for less than they’re worth.”
But it’s equally important to know other major tenets of his approach, which include:
- “Solid fundamentals.”
- “Strong earnings power.”
- “Potential for continued growth.”
Finally, let’s see why the Value factor is so reliable.
2 Schools of Thought for Value
One is called “risk-based,” and the other “behavioral.”
In the case of the Value factor, it seems that both types of explanations apply.
1. Risk-based: On the risk-based side, strong evidence suggests that “cheap” stocks are priced that way for a reason — they’re inherently riskier stocks, so investors aren’t as willing to pay much for them.
One study looked at companies with three specific risk factors:
- Companies that recently cut their dividend by 25% or more (a sign of distress).
- Companies with high debt-to-equity ratios (aka “highly leveraged”).
- Companies that experienced great volatility in earnings (i.e., inconsistent profitability).
When the researchers grouped companies with these three risks — or “distress” — factors and compared their performance to “value” stocks, they found a great degree of correlation, or agreement, between the two groups.
Essentially, this means that “value” stocks are riskier … and so, to hold them, investors demand a market-beating “premium.”
2. Behavioral: There are also a number of “behavioral” explanations for the value factor premium.
One is simply that investors become too pessimistic about the prospects of companies whose stock prices have fallen recently. We extrapolate recent stock performance and recent operational struggles … assuming the company and stock will never turn around.
And when new information comes out about improvements in the company’s operational results and financial metrics … we’re slow to incorporate the news. We thus assign a higher fair value to the stock we’ve been “down” on.
All told, both risk-based and behavioral-based explanations for the Value factor hold up well in academic studies.
It’s likely that both contribute to the persistent outperformance of value stocks over the long run.
Next week, I’ll tell you more about the Green Zone Quality and Growth factors.
To good profits,
Adam O’Dell, CMT
Chief Investment Strategist, Money & Markets