Who is a value investor?

The Conventional Definition: A value investor is one who invests in low price-book value or low price-earnings ratios stocks.

The Generic Definition: A value investor is one who pays a price which is less than the value of the assets in place of a firm.

The Three Faces of Value Investing

1. The Passive Screener: Value Investing based upon screen or screens designed to find value stocks.

2. The Activist Intervener: Investing ìlarge in ìundervaluedî companies

3. Investing in stocks after bad news

I. The Passive Screener

This approach to value investing can be traced back to Ben Graham and his screens to find undervalued stocks. In recent years, these screens have been refined and extended. The following section summarizes the empirical evidence that backs up each of these screens.

A. Ben Grahamí Screens

1. PE of the stock has to be less than the inverse of the yield on AAA Corporate Bonds:

2. PE of the stock has to less than 40% of the average PE over the last 5 years.

3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield

4. Price < Two-thirds of Book Value

5. Price < Two-thirds of Net Current Assets

6. Debt-Equity Ratio (Book Value) has to be less than one.

7. Current Assets > Twice Current Liabilities

8. Debt < Twice Net Current Assets

9. Historical Growth in EPS (over last 10 years) > 7%

10. No more than two years of negative earnings over the previous ten years.

B. Price/Book Value Screens

A low price book value ratio has been considered a reliable indicator of undervaluation in firms. The empirical evidence suggests that over long time periods, low price-book values stocks have outperformed high price-book value stocks and the overall market.

Results from Other Studies

Evidence from International Markets

Country Added Return to low P/BV portfolio

France 3.26%

Germany 1.39%

Switzerland 1.17%

U.K 1.09%

Japan 3.43%

U.S. 1.06%

Europe 1.30%

Global 1.88%

C. Price/Earnings Ratio Screens

D. Price/Sales Ratio Screens

ï Senchack and Martin (1987) compared the performance of low price-sales ratio portfolios with low price-earnings ratio portfolios, and concluded that the low price-sales ratio portfolio outperformed the market but not the low price-earnings ratio portfolio. They also found that the low price-earnings ratio strategy earned more consistent returns than a low price-sales ratio strategy, and that a low price-sales ratio strategy was more biased towards picking smaller firms.

ï Jacobs and Levy (1988a) concluded that low price-sales ratios, by themselves, yielded an excess return of 0.17% a month between 1978 and 1986, which was statistically significant. Even when other factors were thrown into the analysis, the price-sales ratios remained a significant factor in explaining excess returns (together with price-earnings ratio and size).

Determinants of Success at Value Screening

1. Have a long time horizon. All the studies quoted above look at returns over time horizons of five years or greater. In fact, low price-book value stocks have underperformed high price-book value stocks over shorter time periods.

2. Choose your screens wisely: Too many screens can undercut the search for excess returns since the screens may end up eliminating just those stocks that create the positive excess returns.

3. Be diversified: The excess returns from these strategies often come from a few holdings in large portfolio. Holding a small portfolio may expose you to extraordinary risk and not deliver the same excess returns.

4. Watch out for taxes and transactions costs: Some of the screens may end up creating a portfolio of low-priced stocks, which, in turn, create larger transactions costs. (This may be partially mitigated by having a long time horizon). The excess returns reported above are also pre-tax returns. It is possible that these screens may expose the investor to high tax strategies.

II. Activist Value Investing

An activist value investor having acquired a stake in an ìundervaluedî company which might also be ìbadlyî managed then pushes the management to adopt those changes which will unlock this value. For instance,

If the value of the firm is less than its component parts: push for break up of the firm, spin offs, split offs etc.

If the firm is being too conservative in its use of debt: push for higher leverage and recapitalization

If the firm is accumulating too much cash: push for higher dividends, stock repurchases ..

If the firm is being badly managed: push for a change in management or to be acquired

If there are gains from a merger or acquisition push for the merger or acquisition, even if it is hostile

A. Effects of Spin offs, Split offs, Divestitures on Value

The overall empirical evidence is that spin offs, split offs and divestitures all have a positive effect on value.

Market Reaction to Divestiture Announcements

Price Announced

Motive Announced









B. Effects of Leverage Increasing and Decreasing Transctions on Firm Value

The overall empirical evidence suggest that leverage increasing transactions increase value whereas leverage reducing transactions decrease value.

Type of Transaction

Security Issued

Security Retired

Sample Size

2-day Abnormal Returns

Leverage Increasing Transactions

Stock Repurchase





Exchange Offer





Exchange Offer





Exchange Offer





Exchange Offer





Transactions w/ no change in leverage

Exchange Offer





Security Sale





Leverage-Reducing Transactions

Conv.-forcing call





Conv.-forcing call





Security Sale Conv.


Conv. Debt



Exchange Offer





Exchange Offer





Security Sale





Exchange Offer





C. Effects of Management Changes on Firm Value

The overall empirical evidence suggests that changes in management are generally are viewed as good news.



D. The Effects of Hostile Acquistions on the Target Firm

Badly managed firms are much more likely to be targets of acquistions than well managed firms

And acquisitions are clearly good for the target firmís stockholders

Determinants of Success at Activist Investing

1. Have lots of capital: Since this strategy requires that you be able to put pressure on incumbent management, you have to be able to take significant stakes in the companies.

2. Know your company well: Since this strategy is going to lead a smaller portfolio, you need to know much more about your companies than you would need to in a screening model.

3. Understand corporate finance: In a sense, you have to know enough corporate finance to understand not only that the company is doing badly (which will be reflected in the stock price) but what it is doing badly.

4. Be persistent: Incumbent managers are unlikely to roll over and play dead just because you say so. They will fight (and fight dirty) to win. You have to be prepared to counter.

5. Do your homework: You have to be able to form coalitions with other investors and have the capacity to organize to create the change you are pushing for.

III. Contrarian Value Investing: Buying the Losers

Evidence that Markets Overreact to News Announcements

1. Long Term Serial Corrrelation in Returns

One-year and Five-year Serial Correlations - By Size Class

2. Winner and Loser portfolios

Excess Returns for Winner and Loser Portfolios


Good Companies are not necessarily Good Investments

1. Excellent versus Unexcellent Companies

2. Risk/Return by S&P Quality Indices

Conventional ratings of company quality and stock returns seem to be negatively correlated.


Determinants of Success at ìContrarian Investing

1. Self Confidence: Investing in companies that everybody else views as losers requires a self confidence that comes either from past success, a huge ego or both.

2. Clients/Investors who believe in you: You either need clients who think like you do and agree with you, or clients that have made enough money of you in the past that their greed overwhelms any trepidiation you might have in your portfolio.

3. Patience: These strategies require time to work out. For every three steps forward, you will often take two steps back.

4. Stomach for Short-term Volatility: The nature of your investment (companies on the verge of who knows what....) implies that there will be high short term volatility and high profile failures. If you cannot stand the heat, do not sit in the frying pan. (I know ... I know... this is some kind of a mixed metaphor, but it fits.)

5. Watch out for transactions costs: Again, these strategies often lead to portfolios of low priced stocks held by few institutional investors. The transactions costs can wipe out any perceived excess returns very quickly.