Why Value Investing Works

The common explanation is sentiment. What is now unloved will later receive its due. True enough. Value investing certainly does benefit when the unpopular becomes popular. But that is the icing rather than the cake. The happy secret of value investing is that it can succeed even if sentiment remains unchanged.

For why value stocks can prosper even if the marketplace does not re-evaluate its pricing, consider the case of two bonds, each issued with a par value of $1,000 (£784) and a yield of 5%. One of these bonds remains at par, the other does not. For whatever reason – perhaps political instability, perhaps currency weakness – it declines in price so that it trades at $800. It becomes a value bond.

A Tale of Two Investors

Now consider two investors. The first investor is conventional. He has $20,000 at hand and uses that money to purchase 20 lots of the bond that trades at par. In exchange for his expenditure, he will earn $1,000 per year in coupon payments. The second investor is a value buyer. He places his $20,000 into the depreciated bonds. Because that security trades at $800, he receives 25 lots for his transaction, instead of 20. He therefore receives $1,250 in annual payments, making him 25% better off than the conventional owner.

And so things will remain, as long as the two securities maintain their prices. The company that issued the value investor’s bonds need not refurbish its image. Of course, it would be excellent news for the second investor if it did. Were that happy event even to occur, he would enjoy the pleasant choice of continuing to collect $1,250 a year in yield or pocketing a $4,000 capital gain by selling his securities for $20,000. But such good fortune is unnecessary. The value investor needs no marketplace favours to win the battle.

To be sure, stocks are not bonds. Their payouts are considerably less certain. Nonetheless, many stocks, including 85% of S&P 500 constituents, resemble bonds in that they pay dividends. For such securities, the same principle applies.

Take two firms that each have $1 billion in annual sales and $100 million in net income, $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 buys the stock of the optimistically priced firm. That company has a market capitalisation of $3 billion ($100 million of earnings times its P/E ratio of 30), which means that each of its shares costs $50 ($3 billion in market cap divided by 60 million shares). The investor’s $20,000 purchase obtains 400 shares. As each share pays an annual dividend of $0.50, the investor collects $200 each year in dividends.

You probably can guess where this tale is heading. 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.

Objections

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 criticism that carries more weight is that stocks, unlike bonds, have variable payouts. The only calculation that matters for the fixed-income investor who buys on the cheap is whether the security is “money good,” meaning that, despite the current concerns, the issuer will meet its obligations. If that happens, the value owner will succeed, as long as the bond is not further downgraded. 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.

This must be acknowledged. The task of the value buyer is more difficult for stocks than for bonds, which in turn means that value investing for equities suffers longer dry spells. For example, per Morningstar’s indexes, large-company US growth stocks have thrashed their value counterparts over the trailing 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 skepticism, the value-stock buyers have so far been wrong.

The Third Way

Such things do happen. Sometimes value-stock investors will be correct and will comfortably win their contest with growth buyers. Sometimes they will be wrong; then, they will comfortably lose. However, there is also a third possibility. 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.