Value Stocks That Have Been Working

It’s no secret that Value has been cold lately. Although many such stocks have moved off their lows, Value ETFs are, on average, still down 3.68 % in the past year. This does not, however, mean it’s now a bad idea to choose stocks whose prices are reasonable relative to fundamentals. It does, however, mean we have to be especially careful about the fundamentals.

The Essence of Value

Value is not, never was and can never be just about low ratios. Anybody who sorts on the basis of P/E, Price/Sales, Price/Cash Flow etc. and simply buys stocks at the low end of the spectrum is asking for trouble. They may not always get smacked – Lady Luck can accommodate bad ideas for a long time periods. But when the going gets tough, Lady Luck tends to get going; away, far away, from our portfolios.

Stock pricing starts with the academic Dividend Discount Model (DDM), which equates the ideal fair Price to Dividend divided by the difference between Required Return and Growth. In other words:

P = D/(R-G)

(This formulation copes with an unknown holding period but is based on the idea that a stock is worth the present value of the cash flows we expect to receive as a result of ownership; i.e. on the irrefutable logic that no rational person would spend $100 to receive $5.)

This is no secret sauce. Everybody who takes an entry-level investment-finance course learns this very early on. Then, they forget about it (right after taking the exam) because it’s impossible to strictly implement it in the real world. Many stocks don’t pay dividends. G has to be a very low number (to accommodate a theoretically infinite time horizon which is just as well because if G is greater than R, than P will be negative and obviously, that can’t happen).

The key to making this work lies in the words of Carveth Read, to the effect that it’s better to be “vaguely right than precisely wrong” (many erroneously attribute this adage to Keynes). Instead of dismissing the DDM because the only thing we can do with precision is screw it up, we should practice the art of developing vaguely correct approaches to value flavored with an understanding that well conceived vagueness can be more than enough to allow us to achieve investment success.

I start doing this by substituting earnings per share (E) for dividends and doing some algebraic reshuffling and coming up with this:

P/E = 1/(R-G)

That’s no more usable as a precise formula than is the original DDM. But now, we see a roadmap to successful value strategies. P/E does not necessarily have to be lower-is-better, and low P/E, by itself, isn’t good enough. P/E does, however, have to be reasonable in light of 1/(R-G). While it’s still impossible to plug specific numbers into a spreadsheet, we can recognize the relationships and articulate three things we need to consider in the real world, especially when we recognize that R is based on the risk-free interest rate and risk:

As G rises, ideal P/E goes up. You’ve seen that before – it’s the PEG ratio. But PEG is incomplete. We also have two other things to think about.

As Risk goes up (pulling R up with it), P/E goes down and vice versa. That seems counter-intuitive at first glance: Many think of value as a conservative strategy (margin of safety, avoidance of chasing flying stocks, etc.). Not so! All else being equal, you need to pay up (in terms of P/E) for better-quality less-risky stocks.

As interest rates go up (thus pulling R up), P/E goes down and vice versa. You’ve heard this many times in the financial media. Now, you can see exactly how and why it impacts P/E.