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.

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

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.

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.

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.

• In studies that parallel those done on price earnings ratios, the relationship between returns and price book value ratios has been studied.
• The consistent finding from these studies is that there is a negative relationship between returns and price book value ratios, i.e., low price book value ratio stocks earn higher returns than high price book value ratio stocks.
  • Rosenberg, Reid and Lanstein (1985) find that the average returns on U.S. stocks are positively related to the ratio of a firm's book value to market value. Between 1973 and 1984, the strategy of picking stocks with high book/price ratios (low price-book values) yielded an excess return of 36 basis points a month.
  • Fama and French (1992), in examining the cross-section of expected stock returns between 1963 and 1990, establish that the positive relationship between book-to-price ratios and average returns persists in both the univariate and multivariate tests, and is even stronger than the size effect in explaining returns.
  • When they classified firms on the basis of book-to-price ratios into twelve portfolios, firms in the lowest book-to-price (higher P/BV) class earned an average monthly return of 0.30%, while firms in the highest book-to-price (lowest P/BV) class earned an average monthly return of 1.83% for the 1963-90 period.

• Chan, Hamao and Lakonishok (1991) find that the book-to-market ratio has a strong role in explaining the cross-section of average returns on Japanese stocks.
• Capaul, Rowley and Sharpe (1993) extend the analysis of price-book value ratios across other international markets, and conclude that value stocks, i.e., stocks with low price-book value ratios , earned excess returns in every market that they analyzed, between 1981 and 1992. Their annualized estimates of the return differential earned by stocks with low price-book value ratios, over the market index, were as follows:

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%

• Fama and French point out that low price-book value ratios may operate as a measure of risk, since firms with prices well below book value are more likely to be in trouble and go out of business. Investors therefore have to evaluate for themselves whether the additional returns made by such firms justifies the additional risk taken on by investing in them.

• Investors have long argued that stocks with low price earnings ratios are more likely to be undervalued and earn excess returns. For instance, Ben Graham, in his investment classic "The Intelligent Investor", uses low price earnings ratios as a screen for finding under valued stocks.
• Studies which have looked at the relationship between PE ratios and excess returns confirm these priors. Figure 9.12 summarizes annual returns by PE ratio classes for stocks from 1967 to 1988.

• Firms in the lowest PE ratio class earned an average return of 16.26% during the period, while firms in the highest PE ratio class earned an average return of only 6.64%.
• The excess returns earned by low PE ratio stocks also persist in other international markets.

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).

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.

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

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

• Linn and Rozeff (1984) examined the price reaction to announcements of divestitures by firms and reported an average excess return of 1.45% for 77 divestitures between 1977 and 1982.
• Markets view firms that are evasive about reasons for and proceeds from divestitures with skepticism.

Price Announced	Motive Announced
	Yes	No
Yes	3.92%	2.30%
No	0.70%	0.37%

• Schipper and Smith (1983) examined 93 firms that announced spin offs between 1963 and 1981 and reported an average excess return of 2.84% in the two days surrounding the announcement. Further, there is evidence that excess returns increase with the magnitude of the spun off entity.
• Finally, Schipper and Smith find evidence that the excess returns are greater for firms in which the spin off is motivated by tax and regulatory concerns.

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	Debt	Common	45	21.90%
Exchange Offer	Debt	Common	52	14.00%
Exchange Offer	Preferred	Common	9	8.30%
Exchange Offer	Debt	Preferred	24	2.20%
Exchange Offer	Bonds	Preferred	24	2.20%
Transactions w/ no change in leverage
Exchange Offer	Debt	Debt	36	0.60%
Security Sale	Debt	Debt	83	0.20%
Leverage-Reducing Transactions
Conv.-forcing call	Common	Convertible	57	-0.40%
Conv.-forcing call	Common	Preferred	113	-2.10%
Security Sale Conv.	Debt	Conv. Debt	15	-2.40%
Exchange Offer	Common	Debt	30	-2.60%
Exchange Offer	Preferred	Preferred	9	-7.70%
Security Sale	Common	Debt	12	-4.20%
Exchange Offer	Common	Debt	20	-9.90%

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

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.

Evidence that Markets Overreact to News Announcements

1. Long Term Serial Corrrelation in Returns

• While most of the earlier studies of price behavior focused on shorter return intervals, more attention has been paid to price movements over longer periods (one-year to five-year) in recent years.
• There is substantial negative correlation in longer term return intervals, suggesting that markets reverse themselves over very long periods.
• Studies that break down stocks on the basis of market value have found that the serial correlation is more negative in five-year returns than in one-year returns, and is much more negative for smaller stocks rather than larger stocks. The following graph summarizes one-year and five-years serial correlation by size class for stocks on the New York Stock Exchange.

• This phenomenon has also been examined in other markets, and the findings have been similar. There is evidence that returns reverse themselves over long time period.

2. Winner and Loser portfolios

• Since there is evidence that prices reverse themselves in the long term for entire markets, it might be worth examining whether such price reversals occur on classes of stock within a market.
• For instance, are stocks which have gone up the most over the last period more likely to go down over the next period and vice versa?
• To isolate the effect of such price reversals on the extreme portfolios, DeBondt and Thaler constructed
  • a winner portfolio of 35 stocks, which had gone up the most over the prior year, and
  • a loser portfolio of 35 stocks, which had gone down the most over the prior year, each year from 1933 to 1978,
  • Examined returns on these portfolios for the sixty months following the creation of the portfolio. Figure 9.3 summarizes the excess returns for winner and loser portfolios .

• This analysis suggests that loser portfolio clearly outperform winner portfolios in the sixty months following creation. This evidence is consistent with market overreaction and correction in long return intervals.
• There are many, academics as well as practitioners, who suggest that these findings may be interesting but that they overstate potential returns on 'loser' portfolios.
  • There is evidence that loser portfolios are more likely to contain low priced stocks (selling for less than $5), which generate higher transactions costs and are also more likely to offer heavily skewed returns, i.e., the excess returns come from a few stocks making phenomenal returns rather than from consistent performance.
  • One study of the winner and loser portfolios attributes the bulk of the excess returns of loser portfolios to low-priced stocks and also finds that the results are sensitive to when the portfolios are created. Loser portfolios created every December earn significantly higher returns than portfolios created every June.

Good Companies are not necessarily Good Investments

1. Excellent versus Unexcellent Companies

• There is evidence that well managed companies do not always make great investments. For instance, there is evidence that excellent companies (using the Tom Peters standard)

• Unexcellent companies do better than excellent companies :

2. Risk/Return by S&P Quality Indices

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

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.

• Value investing comes in many stripes.
  • There are screens such as price-book value, price earnings and price sales ratios that seem to yield excess returns over long periods. It is not clear whether these excess returns are truly abnormal returns, rewards for having a long time horizon or just the appropriate rewards for risk that we have not adequately measured.
  • There are activist investors who take positions in undervalued and/or badly managed companies and by virtue of their holdings are able to force changes that unlock this value.
  • There are also contrarian value investors, who take positions in companies that have done badly in terms of stock prices and/or have acquired reputations as ìbadî companies.