Why Value Investing Works

The Smart Set
Not so long ago, investment writers appealed to their readers by calling them stupid. “Mutual Funds for Dummies” was the field’s classic (seven editions!), while “The Pocket Idiot’s Guide to Investing in Mutual Funds” served those who were pressed for time. For hopeless cases, there was “The Complete Idiot’s Guide to Making Money with Mutual Funds.” Personal finance for every flavor of blockhead!

This column is offered in that spirit, but sadly such blandishments have become unfashionable. Sometimes, it is useful--even to the author--to consider a subject from first principles, to examine the underlying assumptions. Today’s subject is value investing. Per the academic research, 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  JPMorgan Chase (JPM): Its stock bottomed at $14.96 per share in March 2009 and trades today at $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.

Bonds First
For why, consider the case of two government bonds, each issued with a par value of $1,000 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.

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 country that issued the value investor’s bonds need not refurbish its image. Of course, it would be fine if it did, thereby boosting its bonds’ prices. Then, our value investor would enjoy the pleasant choice of continuing to collect $1,250 per year or pocketing a capital gain by selling his securities. But such good fortune is unnecessary. The value investor needs no marketplace favors to win the battle.

Stocks Second
Some of you will protest, stocks are not bonds. True enough. Nonetheless, many stocks, including 85% of S&P 500 constituents, resemble bonds in that they pay dividends. The same principle then 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 (stifle your surprise) is a value investment. Its stock has a P/E ratio of 15.

Rather than buy government bonds, our conventional investor decides to put his money to work in equities, buying the stock of the optimistically priced firm. That company has a market cap of $3 billion ($100 million of earnings times its P/E ratio of 30), which means that its shares cost $50 ($3 billion in market cap divided by 60 million shares). The investor’s $20,000 obtains 400 shares. As each share pays an annual dividend of $0.50, the investor collects $200 each year in dividends.

You know 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.

Caveats
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 math therefore remains valid, albeit on time delay.

(Yes,  Berkshire Hathaway  (BRK.B) pays no dividend despite being huge and seasoned. That Warren Buffett is a troublemaker.)

The blow that carries more weight is that stocks, unlike bonds, have variable payouts. The only calculation that matters for the value fixed-income investor is whether the security is “money good,” meaning that, despite the concerns, the issuer will meet its obligations. If that happens, the value owner will unquestionably succeed. 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 U.S. 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 were wrong.

Two Out of Three Ain't Bad
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.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.