Value Investing

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Critically evaluate the benefits of Value Investing

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According to Greenwald et al. (2004, p.4)* “…the central process of value investing is
disarmingly simple. A value investor estimates the fundamental value of a financial security
and compares that value to the price Mr. Market is offering for it.”
In light of the above quotation, critically evaluate the benefits of value investing for
investors. Use empirical evidence to support your answer where appropriate.
* Greenwald, C. N. and Kahn, J. Value Investing: From Graham to Buffett and Beyond.
John Wiley and Sons, 2004.

Value investing is a form of philosophical investment strategy which is based on the investment
in securities that have lower prices compared to their intrinsic values. This strategy focuses on
the underlying value of assets as value investors believe that stocks are undervalued by the
market. Value investing can be further categorised into three types which are passive, contrarian
and activist screening (Damodara, 2003, pp. 2). Passive screening follows the idea of selecting
stocks based on certain investment criteria such as low P/E ratio or low price-to-book ratio while
contrarian screening involves the purchase of assets in companies that are out of favour by the
public, and this can be seen through the plummeting of stock prices by a large amount as these
investors assume that the market overreacts to news (Damodara, 2003, pp.2). Activist value
investing is where investors buy stacks of undervalued firms with the objective of intervening in
these firms to remedy the issues that caused the firms to be undervalued in the initial position.
These activist value investors act as catalyst of change such as in improving the corporate
governance in poorly-managed companies (Damodara, 2003, pp.2). This essay will first provide
empirical evidence on the success of value investing, followed by a critical evaluation of the
benefits from value investing to investors and finally, a conclusion.
There exist a large number of academic literatures with empirical evidences on the success of
value investing approach. Investors must first determine a stock’s intrinsic value through the
measurement of stocks values which includes calculating the price-earnings ratio (P/E), price-tobook ratio (P/B), price-to-cash flow ratio, price-to-sales ratio and dividend yields. Value
investors seek to buy stocks that are priced low relative to the firm’s value and one method is by
selecting stocks based on low P/E ratios and high book-to-market ratio. Basu (1997) investigated
1400 industrial firms traded on NYSE between April 1957 and August 1971 and found evidence
of stocks with low P/E ratios outperforming those with high P/E ratios, indicating the superior
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performance of value investment strategies. Portfolios of high book-to-market firms are also
found to have superior returns compared to portfolios with low book-to-market firms (Fama and
French, 1992; 1998; Lakonishok, Shleifer and Vishny, 1994; Rosenberg, Reid and Lanstein,
1984). This is consistent with Chan, Hamao and Lakonishok (1991) study on Japanese firms
where their results showed that high book-to-market stocks generate higher average returns. Lee
& Kwag (2006) also support the idea of value investing strategy that is based on selecting stocks
with high valuation ratios (high earnings-to-price ratio and high book-to-market ratio) as their
results indicate that value investors earn abnormal profit, particularly during contraction periods
than during expansion period. These evidences suggest that value investing strategies are proven
to work and may also indicate the ease of research when it comes to selecting stocks as the
availability of stock-screening tools will allow investors to narrow their searches on stocks based
on the investment factors, rather than having to conduct detailed technical analysis.
Value investors are also known to have a disciplined approach in investing as they adhere strictly
to their philosophical investment strategy. As pointed out by Kahneman and Riepe (1998),
cognitive biases may underlie investors’ behaviours which may affect their judgements and
beliefs, leading to inopportune decisions. Hence, value investors can take advantage of these
market participants who overreact to new information as these market participants are prone to
cognitive biases. This, in turn, will result in securities prices deviating from their underlying
fundamental values in the market (Lakonishok et al 1994 and Chan and Lakonishok, 2004). The
overreaction to news events in stock markets will provide value investors with the opportunity of
purchasing undervalued securities and making abnormal returns in the longer horizon (DeBondt
and Thaler, 1985; 1986). This is because value investors believe that the market will recognise
these undervalued securities and prices will adjust to reflect the intrinsic value in the later period.
Bernard and Thomas (1989) supported this view as their results showed that value investors
earned a higher return because of an under-reaction to news by market participants.
Another benefit of value investing is the lower probability of making a loss as an investor will
purchase stocks with high margin of safety. Margin of safety is defined as the difference between
the intrinsic value of a stock and its market value. A high margin of safety implies a large gap
between a stock’s intrinsic value and market price, indicating that the stock current price is
significantly low.

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However, there are additional risks associated with cheap securities such as those with low P/E
ratios (Chen and Zhang, 1988). According to Fama and French (1992), they argued that the
higher returns from value investing strategies involve undertaking higher risks. Stocks with high
book-to-market ratios are more susceptible to financial distress and therefore, have higher returns
in order to compensate for the higher risks (Fama and French, 1996). These companies may be
sending a warning in the form of high book-to-market to suggest that they might be facing
financial problems and may face bankruptcy or forced liquidation. Hence, investors will have to
decide if the extra returns are a fair justification of the high risks involved (Damodara, 2003,
pp.11-12).
As value investing is considered a long term strategy, it will take a significant amount of time
before investors can gain abnormal profit. Aboody et al (2002) assumed that the market is
inefficient and thus, there are discrepancies between the securities’ market prices and their
intrinsic values. This is consistent with Rousseau & Rensburg (2004) who did a study on a
sample of JSE stocks between 1982 and 1988. They concluded that value investing performance
becomes more pronounced as the time horizon increases. Holthausen and Watts (1992) suggested
that this higher return as a result of the longer time horizon is because the longer time period is
able to reduce market inefficiency. Hence, value investors have to be patient as they have to wait
for a longer time period before they can earn an abnormal profit.
The purpose of having a diversified stock portfolio is to reduce the amount of risk an investor
will have by spreading out risk across a portfolio. Damodara (2013, pp. 22) stated that value
investors may not follow this technique of diversifying as they are too concern with stock
screening method. In addition, stocks with low price-to-earnings ratio either have higher
dividend yields or are subjected to high-risk earnings (Damodara, 2013, pp.16). Value investors
may face high tax rate because of higher dividend yields generated by stocks with low price-toearnings ratio. The low P/E ratio may also be a result of manipulation in the earnings per share
figure as accounting data such as earnings per share is susceptible to management manipulation
(Damodara, 2013, pp.16). Value investing is also a subjective concept as it is difficult to
determine the intrinsic value and the margin of safety precisely. This is particularly for margin of
safety as there are situations where the margin of safety is not large enough to justify the lower
quality stocks.

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To summarise, the underlying strategy of value investing is to invest in securities that are trading
below their intrinsic values. This strategy involves the selection of securities based on value
screening methods such as book value multiplies and earnings multiples. There exists a large
number of empirical evidence which support value investing strategies as value investors earn
higher returns compared to growth investors (Fama & French, 1992; Basu, 1977; Chan, Hamao
and Lakonishok, 1991). Value investors also have a disciplined approach to investment than
other investors who display herding behaviour. Value investors also do not react to short term
market fluctuations and thus, are not required to make adjustments to their stocks instantly when
there are changes to the stocks’ prices. Instead, value investing allows them to earn abnormal
profit based on the market volatility. The pricing of securities in the market are often influenced
by psychological and social factors and this is a reason for market inefficiency (Lowenstein,
2006). However, a value investor who earns a higher return will need to bear higher risk as
pointed out by Fama and French (1992). Furthermore, value investing requires patience as it is a
long-term strategy and there are problems in measuring intrinsic values and in defining the
margin of safety as both these measurements are subjective concepts. Financial ratios such as
price-to-earnings ratio are also susceptible to management manipulations. It is worth noting that
the two notable and successful investors employing value investing techniques are Benjamin
Graham and Warren Buffet. They have proven that value investing generates higher returns over
a long term. This, together with the empirical evidence, showed that value investing offers
benefits to investors. However, these strategies are only successful for investors who are
discipline, patient and are able to understand the fundamentals of the invested companies. Only
with these traits can an investor gain benefits from value investing.

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References:
Aboody, D., Hughes, J., Liu, J. (2002) ‘Measuring Value Relevance in a (Possibly) Inefficient
Market’, Journal of Accounting Research, Vol. 40, No. 4, pp. 965-986
Basu, S. (1977) ‘Investment Performance of Common Stocks in Relation to Their Price-Earnings
Ratios: A Test of the Efficient Market Hypothesis’, Journal of Finance, Vol, 32, No, 3 pp. 663682
Bernard, V. L. and Thomas, J. K. (1990) ‘Evidence that stock prices do not fully reflect the
implications of current earnings and for future earnings’, Journal of Accounting and Economics,
Vol. 13, pp. 305-340
Chan, L. K. C., Hamao, Y. and Lakonishok, J. (1991) ‘Fundamentals and Stock Returns in
Japan’, Journal of Finance, Vol. 46, No. 5, pp. 1739-64
Chan, L. K. C. and Lakonishok, J. (2004) ‘Value and Growth Investing: Review and Update’,
Financial Analyst Journal, (January/February), pp. 71-85
Chen, N. and Zhang, F. (1998) ‘Risk and return of value stocks’, Journal of Business, Vol. 71,
pp. 501-535
Damodaran, A.. (2012). Chapter 8. In: Investment Philosophies: Successful Strategies and the
Investors Who Made Them Work. Hoboken, New Jersey: John Wiley & Sons, pp. 2, 11, 16, 22
DeBondt, W. F. M. and Thaler, R. H. (1985) ‘Do the Stock Market Overreact?’, The Journal of
Finance, Vol. 40, No. 3, pp. 793-805
DeBondt, W. F. M. and Thaler, R. H. (1986) ‘Further Evidence on Investor Overreaction and
Stock Market Seasonality’, The Journal of Finance, Vol. 42, No. 3, pp. 557-581

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D. Kahneman and M. W. Riepe (1998) ‘Aspects of investor psychology’, Journal of Portfolio
Management, Vol. 24, No.1, pp. 52–65
Fama, E. F. and French, K.R. (1992) ‘The Cross- Section of Expected Stock Returns’, Journal of
Finance, Vol. 47, No. 2, pp. 427-465
Fama, E. F. and French, K.R. (1998) ‘Value versus Growth: International Evidence’, The Journal
of Finance, Vol. 53, No. 6, pp.1975-1999
Holthausen, R. W. and Larcker, D. F. (1992) ‘The Prediction of Stock Returns Using Financial
Statement Information’, Journal of Accounting and Economics, Vol. 15, No. 2,3, pp. 373–411
Kwag, S.W. and Lee, S.W. (2006) ‘Value investing and business cycle’, Journal of Financial
Planning, Vol. 19, No. 1, pp. 64-71
Lakonishok, J., Shleifer, A. and Vishny, R. W. (1994), ‘Contrarian Investment, Extrapolation, and
Risk’, Journal of Finance, Vol. 49, No. 5, pp. 1541-1578
Lowenstein, L. (2006) ‘Searching for Rational Investors in a Perfect Storm: A Behavioral
Perspective’, Journal of Behavioral Finance, Vol. 7, No. 2, pp. 66-74
Rosenberg, B., Reid, K. and Lanstein, R. (1984) ‘Persuasive evidence of market inefficiency’,
Journal of Portfolio Management, Vo. 11, pp. 9-17
Rousseau, R. and Rensburg, V. P. (2004) ‘Time and the payoff to value investing’, Journal of
Asset Management, Vol. 4, No. 5, pp. 318-325

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