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Why value investing works

John Rekenthaler, CFA  |  05 Jul 2018Text size  Decrease  Increase  |  
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Tortoise versus hare - investing choices

Sometimes it is useful to consider an investment subject such as value investing from first principles. The academic research backs the idea that buying stocks on the cheap has flourished for as long as the data has existed. Why?

The common explanation is sentiment. What is now unloved will later receive its due. A classic case would be US investment banking giant JPMorgan Chase: its stock bottomed at US$14.96 per share in March 2009 and trades today at US$104. Nine years ago, bank stocks were very unpopular. Now they are not. Those who foresaw that change, and who were brave enough to purchase the stock when others feared, have reaped their just rewards.

The anecdote is useful, but incomplete. It is true that value investing benefits when the unpopular becomes popular. But that's the icing rather than the cake. Value investing succeeds even if sentiment remains stable.

Take two firms that each have US$1 billion in annual sales and US$100 million in net profits, US$30 million, of which is distributed as dividends. The two companies have each issued 60 million shares of equity. The first company is optimistically priced, with its stocks boasting a price/earnings ratio of 30. The second is a value investment. Its stock has a P/E ratio of 15.

Our conventional investor decides to buy the stock of the optimistically priced firm. That company has a market cap of US$3 billion – US$100 million of earnings times its P/E ratio of 30 – which means that its shares cost US$50, ie. US$3 billion in market cap divided by 60 million shares. The investor’s US$20,000 obtains 400 shares. As each share pays an annual dividend of 50 cents, the investor collects $200 each year in dividends.

Because the value investor’s stock trades at half the P/E ratio of the conventional investor’s, the company’s market cap and share prices are also halved. The value investor lands 800 shares of his securities, at $25 each. Thus, he receives $400 in annual dividends, double his rival’s amount.

Dividends the key

There are two objections to this reasoning. One may be readily dismissed, and one cannot.

The readily dismissed argument is that some stocks do not pay dividends. However, nearly all will do so eventually, should they live long enough. If the non-dividend-paying company does not survive to reach maturity, then neither of our hypothetical investors will have won. They both will have lost money on a dud stock. The maths therefore remains valid, albeit on time delay.

The blow that carries more weight is that stocks have variable payouts. With stocks, the path of future earnings, and thus of future dividends, is uncertain. The expensive stock may grow its dividends so aggressively that its payouts easily outpace those of the value investor.

Value investing for equities suffers longer dry spells. For example, as Morningstar’s indices show, large-company US growth stocks have thrashed their value counterparts over the last five years. This has occurred because profits from the tech giants have outstripped even the lofty forecasts. The growth-stock buyers were right and, in their scepticism, the value-stock buyers were wrong.

Such things do happen. Sometimes value-stock investors will be right and will comfortably win their contest with growth buyers. Sometimes they will be wrong; then, they will comfortably lose. But sometimes, expectations will remain stable, so that neither party gains relative ground. It is during that third scenario when value investing demonstrates its true strength.

 

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John Rekenthaler is vice president of research for Morningstar, based in the US. He is a columnist for Morningstar.com and a member of Morningstar's investment research department. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is Vice President of Research for Morningstar.

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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