Why Value Investing Works

Investors in value stocks have suffered a long dry spell in recent years, but they can still win the race against growth stocks

John Rekenthaler 3 July, 2018 | 9:51AM

Tortoise versus hare - investing choices

Sometimes it is useful to consider an investment subject such as value investing from first principles. The academic research backs the idea that 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 US investment banking giant 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.

Take two firms that each have $1 billion in annual sales and $100 million in net profits, $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 is a value investment. Its stock has a P/E ratio of 15.

Our conventional investor decides to buy 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, ie. $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.

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.

Dividends the Key

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 maths therefore remains valid, albeit on time delay.

The blow that carries more weight is that stocks have variable payouts. 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.

Value investing for equities suffers longer dry spells. For example, as Morningstar’s indices show, large-company US growth stocks have thrashed their value counterparts over the last 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 scepticism, the value-stock buyers were wrong.

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.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
JPMorgan Chase & Co114.35 USD0.45
About Author John Rekenthaler

John Rekenthaler  is vice president of research for Morningstar.