Value investing: A taste for value

Part five of our “Six Winning Strategies to Build Your Wealth” series:
Love a good bargain? Check out value investing. It’s not for beginners, but with a little patience this strategy can produce stunning results.

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by Norm Rothery
October 27th, 2010

From the September/October 2010 issue of the magazine.

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invest_120
What I learned as a value investor

Lou Bielmann, 51
Stay-at-home dad; London, Ont.

I’m a retired airline pilot. I flew for 25 years, but now all I do is manage our family’s accounts. I started reading about investing around 1998 and I explored all kinds of different things. Very quickly I became convinced that value investing is the most rational and safe way to invest.

If you’re interested in value investing, you should learn about the philosophy behind it. Benjamin Graham wrote a good book on the subject called The Intelligent Investor. Then be patient. You need to wait for the market to become irrational—overly fearful—so you can pick up companies for less than they’re worth. Value investing is easy to understand, but extremely difficult to carry out, because the best bargains come at times when fear and pessimism are at peak levels.

You also have to watch out for too much optimism: The last few years taught me that if I think the overall market is too pricey, then it’s time to hedge or otherwise reduce my risk.

Since 2001, I have enjoyed an average annual return just shy of 10%, although not all that is from my value stocks. I’m very satisfied with the performance so far. Right now we have 10 kids in the house, including adopted and foster children. The success I’ve had investing allows me to be here with our family, and it’s a lifestyle I appreciate.

…..

 There are many paths to investment nirvana but if you love a bargain, you’ll be particularly fond of value investing. Hunting for value stocks is a bit like searching for a good deal in the supermarket. Essentially, you’re aiming to pile your cart high with stocks that are trading at low prices relative to their fundamentals.

What are value stocks? As Century Management’s Arnold Van Den Berg once sensibly observed, they are stocks that fell in the bargain bin when sellers got emotional. Perhaps a stock hasn’t done much, price-wise, for years and it gets dumped out of apathy. Perhaps the firm sells out-of-favour products like old-fashioned paper books and the company is sold out of disgust. Fear and panic are classic motivations which frequently arise during market crashes or when a firm runs into difficulty. Emotional sellers often overreact on the downside and, as a value investor, that’s your cue. Frequently the worst fears of the sellers are not realized and the stock recovers in the fullness of time as the worries abate. The key to value investing is to buy these stocks while they’re underpriced, then sell them once the market has realized that they’re worth much more.

How have value stocks performed? Bargain shopping doesn’t sound like the path to eye-popping returns, so you may be surprised by just how well they’ve done over time. In the last 30 years, a portfolio of U.S. stocks with the lowest 30% of price-to-book-value ratios would have delivered 13.6% average annual returns, compared to 11.2% for the S&P 500.

The revealing ratio. In general, good candidates for a value portfolio are those stocks with low price-to-book-value (P/B) ratios. You can calculate this ratio by dividing a stock’s price-per-share by its book-value-per-share. A company’s book value, or shareholders’ equity, is a measure of how much you’d get if you sold off a firm’s assets (at balance sheet values) and then paid off all of its liabilities. Thus stocks with P/B ratios of less than 1 are selling for less than their balance sheet says they are worth.

In addition to searching out stocks with low P/B ratios, you should look for reassurance that the company isn’t likely to go bust. That’s why many value investors focus on firms that have earned at least some money over the last year. In addition, large companies tend to be more stable, so you may want to opt for U.S. stocks with market capitalizations of $5 billion and up. The 10 most interesting value candidates that pass these tests are shown in the “Book value bargains” table at the bottom of this page.

Even after satisfying all of those criteria you should do a little extra digging and examine each company in detail before taking the plunge. After all, as a buyer of potentially broken goods, a value investor must fully suss out why a stock is trading so low. Keep in mind you can’t expect value stocks to suddenly surge higher. It often takes several years to see success—but investors with a long-term orientation know that the value path is well worth taking. Should all go well, you’ll be able to sell after a nice run when a stock trades at substantial premium to book value.

What can go wrong? A value stock’s fundamentals can deteriorate. Perhaps business sags and the firm loses pots of cash. As a result, its book value shrinks and its price declines. Sometimes a firm will even go bankrupt. (Many big-name value investors lost money on Canwest, for instance.) Regrettably, every value investor eventually runs into such unfortunate cases and that’s why diversification is advisable.

There are also periods when value stocks, as a whole, lag the market and they can last for several years. Such trying times can test the mettle of investors, who may be lured to riskier strategies. Indeed, many investors bailed on value during the internet bubble of the late 1990s only to see their portfolios fall into ruin. 

Also, stocks with low P/B ratios are often small firms (by market capitalization) and they tend not to trade frequently. Both of these features can be intimidating to some investors. Even large value stocks can be difficult to hold due to the bad news that surrounds them. As a result, novice investors might want to opt instead for the high-dividend-yield approach, which is a mild form of value investing. It doesn’t do quite as well, but the ride tends to be more comfortable.

Book value bargains

These stocks have P/B ratios of less than one, so they’re selling for less than their balance sheets say they’re worth. Each also has recent earnings and a market cap of more than $5 billion.

Company Market cap ($mil) Price P/B P/E Yield
Constellation Energy (CEG) $6,166 $31.15 0.70 14.56 3.1%
CNA Financial (CNA) $7,647 $28.43 0.75 7.65 0.0%
Capital One Financial (COF) $18,756 $41.93 0.75 8.86 0.5%
Ameren (AEE) $6,249 $26.11 0.79 10.12 5.9%
PartnerRe (PRE) $5,907 $72.83 0.79 6.47 2.7%
ACE Ltd. (ACE) $18,068 $53.32 0.84 6.68 2.5%
Unum Group (UNM) $7,389 $22.73 0.86 8.68 1.6%
Allstate (ALL) $15,170 $28.55 0.87 8.60 2.8%
Loews (L) $15,813 $37.53 0.90 8.90 0.7%
Prudential Financial (PRU) $25,904 $57.12 0.98 9.47 1.2%
Source: Globeinvestor.com, yahoo.com, August 3, 2010

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