The Investment Scientist

Is value investing still valid?

Posted on: August 10, 2012

New York Stock Exchange

Value investing as an investment discipline was pioneered by Ben Graham and is practiced by Warren Buffett.  It has a long history of data collection and many rigorous studies done in the most prestigious research universities.

The idea of value investing is that undervalued stocks will ultimately outperform overvalued stocks in aggregate.

There are four simple measures one can use to determine if a stock is relatively undervalued or overvalued….

P/E ratio is the most common one; it is the ratio between price and earning.  The higher the ratio, the more overvalued is the stock. In a post titled “Is P/E a useful stock valuation measure?” I showed that low P/E stocks outperformed high P/E stocks in aggregate.

When some clients of mine wanted to invest in the Facebook IPO, I used this measure to convince them that Facebook was overvalued at nearly 100 P/E. Comparatively, Google only has a P/E of 14; Apple, 12; and Microsoft, 10. Four stocks do not amount to an aggregate, so I cannot rule out the slim possibility that Facebook  will perform the best. But the possibility is so slim, it does not justify investing in it.

Another measure commonly used by investors is P/D, or price-to-dividend ratio. It is the inverse of dividend yield.  There is clear historical evidence that the higher the P/D ratio, the more overvalued is the stock. In this article I wrote at the thick of the financial crisis four years ago, I showed that low P/D stocks (or high dividend yield stocks) did exceptionally well, particularly during recessions.

Academics like to use a third measure for stock valuation – P/B, or price-to-book ratio. This ratio compares market value of a stock to its accounting book value.  The higher the ratio, the more overvalued is the stock. In the table below, I show the comparative ten-year returns of three groups of stocks: top 30% in P/B ( relatively overvalued), medium 40% in P/B (fairly valued), and bottom 30% in P/B (relatively undervalued.) The data come from Professor Kenneth French’s data library.

Period Overvalued Fairly-Valued Undervalued
1962-1971 103% 80% (worst) 230% (best)
1972-1981 58% (worst) 170% 292% (best)
1982-1991 360% 344% (worst) 437% (best)
1992-2001 205% (worst) 319% 437% (best)
2002-2011 43% (worst) 56% (best) 47%

As you can see, in the past five decades, undervalued stocks (according to P/B measure) are the best performers in four decades, while overvalued stocks are the worst performers in three decades.

Note that undervalued stocks do not perform well every year.  In fact, last year they performed the worst – but the odds favor them performing the best over the long run.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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