Screening for Value – An Introduction

Many here will know me from my book, Excellent Investing, which teaches investors how to build a better investment portfolio. Others will have seen some of the educational talks I’ve given at various Mello events. Given the wide breadth of topics I usually cover, some people will be unaware of my personal investment philosophy: I am a value investor.

Value Investing has a long history, the origins of which most people trace back to Benjamin Graham. Stockopedia subscribers are used to having a legion of investment metrics and tools at their fingertips. However, when Graham began his career early in the 20th Century, the idea that a stock could be understood more deeply by a rigorous analysis of the accounting figures was a niche view. Back then, it was far more common for stock market investors to invest on a hunch rather than delve into the details of the financials. Often stock market investing was simply a form of speculation, and lightly regulated brokerages called ‘bucket shops’ were a common way for individuals to bet on the direction of stocks or commodities. Given the rise of speculation in lightly regulated “assets” in the past couple of years, perhaps some things haven’t changed!

In his first book, Security Analysis, which was co-written with David Dodd in 1934, Graham shunned such speculative pursuits. In contrast, he strongly encouraged investors to take a conservative approach to their investment practice. He viewed each investment as owning part of a business, not a piece of paper.

Graham’s second book, The Intelligent Investor, was published in 1949 and became the defining value investing tome. In it, he suggests ignoring, or taking advantage of, the wild swings in the mood of the manic ‘Mr Market’. Graham viewed the market as a voting machine in the short term but a weighing machine in the long term. Accordingly, he implored readers to weigh their investments and take advantage of those market participants whose voting unnecessarily moved stock prices.

It was Graham whom Warren Buffett chose to work for, for free, to learn his ways. Since then, many successful investors have chosen a value investing path, each adding their own unique flavour. While Walter Schloss closely stuck to Graham’s methods, Buffett transitioned to buying wonderful companies at fair prices rather than fair companies at wonderful prices. David Dremen applied the value principles purely quantitatively over many stocks, while Joel Greenblatt looked for just a few special situations. Most investors applied the principles to the equity markets, whereas Howard Marks applied them to the debt markets. In addition to buying undervalued stocks, Bill Ackman and David Einhorn were willing to short those stocks they considered to be overvalued. They were also driven to be more activist investors, publicly criticising managements they believed were not acting in shareholders’ best interests - something Graham pioneered. While they differed in style, each of these investors was successful because they took advantage of the manic ‘Mr Market’ and his mood swings.

Despite this long history, there can still be varying views on what constitutes a Value Investor, so let me offer up my own definition:

A value investor is one whose primary reason for investing in a stock is a perceived difference between the fundamental value of the underlying business and the price at which the market currently offers the investor the opportunity to purchase part ownership of that business.

Many value investors will use additional tools above and beyond this criterion in their stock selection. For example, they may conduct a balance sheet analysis to minimise the risk of bankruptcy or use charts to time their entry into a stock. However, for a value investor, these additional tools will never be the primary reason for purchasing a stock. Instead, these will always be secondary considerations that investors use only when they have identified a significant difference between valuation and price. Conversely, a value investor will never buy into a company they believe to be overvalued, no matter how strong the management team or the stock’s recent price action is.

With a clear idea of what constitutes a value investor, we can explore the characteristics of value investing more fully. In my upcoming article series, I will explain why value investing still has the ability to generate market-beating returns after all these years. I will show how to use the Stockopedia tools, such as Stock Screens, to find investment ideas and look into the details of some of the stocks that these tools highlight. I will describe the unique mindset that being a value investor requires. Value investors also tend to make common mistakes, and I will show how to overcome or mitigate these weaknesses.

Value investing - the time is ripe

Up until the end of last year, many commentators were declaring that “Value is Dead” based on a decade-long period of the underperformance of low price-to-book companies to high price-to-book ones in the US markets. The theory was that economies of scale, and intangible assets, which are not always accurately captured by accounting metrics, matter far more in the modern economy than tangible assets. While there is certainly some truth in that assertion, this didn’t explain why almost all pre-profit, and even pre-revenue, stocks soared whatever industry they were in. Researchers from AQR Capital Management recently published a paper looking into these issues called Is Systematic Value Investing Dead?. This looked at a series of possible rationalisations of the recent underperformance of value strategies and found little empirical evidence or theoretical foundation to support these.

Since then, value, as measured by quantitative metrics, has made a big comeback, as the following overlay of the Russell 2000 Growth and Value ETFs shows:

But despite this resurgence, the graph also shows that it has not yet recovered its underperformance of the last decade. Given the long-term nature of these cycles, it is likely that value will continue to outperform for some time yet. A background of higher inflation and higher interest rates will continue to remove speculative froth from valuations and favour companies with higher near-term profits and cashflows.

Despite this being a fortuitous time to be a value investor, the link between value investing and other styles such as quality, growth, or momentum is closer and much more nuanced than many investors may think. Over the coming weeks, I will explain how all styles of investors can benefit from understanding a conservative valuation-based approach, even if they apply it somewhat differently.

Current market conditions make it a challenging environment for all investors. While a value approach does not provide immunity from these difficulties (at least some of the recent value outperformance has been lower falls rather than absolute gains), the ability to “weigh” investments and adopt a long-term mindset can help investors rise above the noise of short-term “voting”. I hope subscribers find this fresh perspective on all things value both relevant and timely.

To kick off the series I will take a closer look at the value investing mindset and introduce my first value investing screen.