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George Athanassakos  

Fred Lum/Fred Lum/The Globe and Mail

Value investing is all about stock picking. It is a style of investing that helps one find and buy stocks that trade significantly below intrinsic value. According to the father of value investing, Ben Graham, a value investor wants to buy a stock that is worth one dollar for 50 cents. While this is common knowledge, there is, in general, lack of in-depth understanding of what value investing is in terms of who the value investors are, what they believe in, what process they follow, whether such process works and why. I will try to set the record straight in this article.

Who are the value investors?

They are long-term bottom-up fundamental analysts who arrive at an intrinsic value of a stock using long-term fundamentals. Such intrinsic value is not affected by short-term announcements and press releases, but by such factors as whether the company operates in a free-entry environment or not, whether it is well managed, whether it has a good business model and whether it is conservatively financed. If the stock price is well below the intrinsic value, by what is known as the margin of safety, then value investors buy in, otherwise they stay on the side lines.

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What do they believe in?

Their principles are key in what value investors believe. First, they believe that when you buy a stock, you do not buy a piece of paper. Instead you buy the company and you should know a lot about the company. As one cannot know much about a lot of companies, value investing involves holding a concentrated portfolio of stocks. Second, since stocks a lot of the time go up or down for reasons unrelated to fundamentals, one must try to take advantage of such movements as opposed to following them. This means that when everyone is exuberant, one must be cautious and when everyone panics, one should look for opportunities. Third, we must always look for the margin of safety. The margin of safety was 50 per cent at the time of Ben Graham, but has come down to one-third of the intrinsic value in current times. Since valuation deals with the future in an uncertain world and so is subject to mistakes and inaccuracies, the margin of safety protects your downside.

What process do they follow?

To find stocks that are worth one dollar but trade for 50 cents, value investors follow a three-step process. First, they screen stocks by forming quartiles based on a number of metrics such as price-to-earnings, price-to-book, market capitalization, etc., and focus on stocks in the lowest quartile. This screening allows them to identify possibly undervalued stocks and reduce the number of stocks they will consider in depth. Second, the possibly undervalued stocks from the first step are now valued to determine their intrinsic value using both asset-based and cash-flow-based valuation approaches. Third, they make a decision using the concept of the margin of safety. A stock is truly undervalued only when its price is below the intrinsic value by at least one-third. These are the stocks they buy.

Does value investing work?

Academic research has shown that it works. Value stocks beat growth stocks in the long run by anywhere between 7 and 13 per cent depending on the market and the country. And this outperformance is not because value stocks have higher risk than growth stocks. Evidence shows that value stocks have lower betas than growth stocks; they outperform in bad and good economic and market conditions and when news is good and when it is bad.

Why does value investing work?

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It is because of the interaction of weaknesses in human nature and conflicts that portfolios managers have when they manage other people's money that biases stock prices leading to the outperformance of value investors. Humans are not rational. They naively extrapolate past performance, they overact, they are overoptimistic and overconfident and they herd. They are also impatient and panic. That is why, while the average mutual fund has returned more than 8 per cent annually in the United States over the past 30 years, the clients who have invested in these funds have only made 2 per cent.

At the same time, institutional investors have conflicts when they manage other people's money. They adopt a herd mentality to protect their jobs, they systematically rebalance their portfolios throughout the year to affect their Christmas bonus and they window-dress the last quarter of the year to spruce up their portfolios so that when they send clients the annual reports, it will be seen that they only hold good, glamour stocks. These conflicts are the cause of the well-known January effect and the reason why the best time to find truly undervalued stocks is the last quarter of the year. As human nature weaknesses and institutional biases are not going to go away any time soon, value investing will continue to work irrespective of how many people study value investing or insist they are value investors.

There you have it. While everyone wants to say they are value investors, only a few really are.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

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