Five approaches to value investing

In investing circles, value and growth are often juxtaposed as distinct investment strategies. Arguably, though, this distinction is artificial – after all, for many investors, the attributes of value and growth go hand-in-hand when it comes to selecting stocks. Warren Buffett put the point succinctly in his letter to shareholders of Berkshire Hathaway Inc back in 2000:

Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation.

Still, what about that value equation? Regardless of an investor’s overall approach, understanding why value investing has been so successful is an essential part of the investment toolkit – even when seeking out tomorrow’s growth stars.

Five Approaches

What can motivated value hunters do to try and find potential buying candidates? There are at least five distinct value-based investing approaches, probably more, but these are some of the most interesting ones:

1. Deep Value (Bargain Stocks)

Deep value investing strategies were pioneered by the faster of value investing, Ben Graham. He took price-to-book as a measure of value and pushed it a stage further with what is known as NCAV investing – or the scrutiny of a company’s net current asset value. The method involves taking current assets (such as cash, stock and debtors) on the basis that these items could easily liquidated in the event of total failure, and then subtracting the total liabilities to arrive at the NCAV. Any stock trading at a market price lower than NCAV was a potential prospect (although there were other stipulations) and Graham also looked for a margin of safety of about 33% below that level.

He also developed his ‘defensive’ and ‘enterprising’ approaches (depending on the experience of the investor). The rarity with which defensive screen candidates appear means that it is probably the ‘enterprising’ strategy that offers most interest for serious investors. In it, he suggested looking at i) the relatively unpopular large company, ii) “special situations”, and iii) “bargain issues”. This is not an easy approach to employ, though. As he wrote:

“The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average.”

It's also very important to avoid value traps with this kind of extreme bargain approach.

2. Bargains in Recovery (Piotroski)

One of the issues with value stocks is that you tend to be buying quite troubled and difficult companies – someone once called it a “hold your nose and buy” strategy. The risk therefore is that you invest in a stock which either goes bust or simply fails to ever recover (known as “a value trap”). Diversification is one way around this but another neat option for investors that want to have more comfort over their value stocks is the F-Score, which was developed by Stanford accounting professor, Joseph Piotroski. The F-Score is a simple indicator to highlight stocks showing the most likely prospects for outperformance amongst a basket of apparently undervalued companies. After defining the bottom 20% of the market based on price-to-book valuations, Piotroski tests each stock with nine accounting-based criteria spanning profitability signals, leverage, liquidity and source of funds and operating efficiency. By apply some demanding fundamental analysis, his aim is to discover why each company is being undervalued, whether it is justified and which of them offers the best chance of recovery… and then buy them cheaply.

3. Value on the Move (Lakonishok)

Having earlier referenced the influence of academic research by Josef Lakonishok, it is worth noting that he (together with Andrei Shleifer and Robert Vishny) went on to set up LSV Asset Management, which currently manages $58 billion across its value equity portfolios. Tackling this issue of value traps, Lakonishok’s approach is to find under-valued, out-of-favour companies at the point when the market is starting to recognise them. From a fundamentals perspective, he begins by looking at price-to-book, price to-cash flow, price-earnings and price-to-sales ratios in order to identify unloved stocks. He then looks for those shares that are showing sign of momentum, either in terms of price momentum (relative strength) or in terms of improving analyst sentiment and earnings surprises.

Importantly, Lakonishok also puts great emphasis on behavioural finance – his research suggested that ‘glamour stocks’ often underperform value stocks because investors naturally gravitate towards popular shares, which inevitably drives up their prices to a level that doesn’t match their fundamentals. So he suggests avoiding the tendency to extrapolate the past too far into the future, to wrongly equate a good company with a good investment irrespective of price, to ignore statistical evidence and to develop a “mindset” about a company.

4. Cheap but Good (Magic Formula)

For Joel Greenblatt, the founder of successful New York hedge fund Gotham Capital, the mantra of ‘buy cheap, sell high’ underpins his now legendary strategy of Magic Formula investing.

However, rather than just focusing on the cheapest possible stocks, Greenblatt adds a filter for quality. The Magic Formula looks at two metrics in a given stock: a high return on capital and a high earnings yield – or, to put that another way, it has to be ‘good’ and ’cheap’. Greenblatt’s criteria puts the focus on how effective a company is at making a profit from its assets and then values it by taking its operating profit and dividing it by its enterprise value – the higher the earnings yield the ‘cheaper’ the stock. By ranking the market from high to low for each indicator and adding the two ranks an investor can come up with a ‘Magic Formula’ score for all the eligible companies in the market.

The idea is that, by selecting a basket of between 20 and 30 such stocks, an investor can mitigate the likely individual disappointments from some stocks in this screen by putting trust in the ‘quant’ that it won’t need too many successes for the strategy to pay off.

5. Quality at a Fair Price (Buffett)

At the far end of the value vs. quality spectrum lies Warren Buffett. We have discussed elsewhere the investment criteria of Warren Buffett, but it would be an oversight not to mention the inspiration taken from the value investing school of the world’s most successful living investor. Buffett was mentored by Ben Graham and has acknowledged his influence on his investing philosophy. Having said that, Buffett also puts great emphasis on the calibre of the business franchise and the management, and has moved on from what he calls “cigar-butt” investing In essence, he looks for simple, understandable companies that have a monopoly position and pricing power (for example, through strong brand recognition), so as to ensure consistent profits and a good return on equity. So he’s willing to pay up for a business franchise but – like the good value investor he once was– only where the price is still at a significant discount to the underlying intrinsic value.

The Value Quest

While the debate over the merits and risks of value investing is as old as the hills and may run forever, understanding the techniques applied by successful investors to identify value is probably more useful for practical minded investors. Within the “value school”, you will have seen that there are a range of different approaches – from Ben Graham’s pure bargain hunting at one extreme to Warren Buffett’s quality focus at the other – and they are all worth reading up on to develop your own view of what represent "value" when stock-picking.