Value Investing and Mr. Market
In an era of hot markets and wild speculation it is useful to
consider a well-seasoned and more conservative value approach. To
assist in telling the value story, I start with Benjamin Graham's
Mr. Market parable which he spun in his book The Intelligent
Investor:
"Imagine that in some private business you own a small
share that cost you $1,000. One of your partners, named Mr. Market,
is very obliging indeed. Every day he tells you what he thinks your
interest is worth and furthermore offers either to buy you out or sell
you an additional interest on that basis. Sometimes his idea of value
appears plausible and justified by business developments and prospects
as you know them. Often, on the other hand, Mr. Market lets his
enthusiasm or his fears run away with him, and the value he proposes
seems to you a little short of silly."
Value investing is all about figuring out when Mr. Market is overly
enthusiastic or fearful and then taking advantage of the situation.
Graham suggested that companies with low Price to Earnings (P/E) and
Price to Book (P/B) ratios are likely those that have been priced by a
fearful Mr. Market. On the other hand, high P/E and P/B ratios
likely indicate an enthusiastic Mr. Market. The P/E ratio can be
found in most newspapers and is determined by dividing the company's
price per share by its annual earnings per share. The P/B ratio may
be unfamiliar to some investors; it can be determined by taking a
stock's price per share and dividing it by the value of the company's
assets per share. Graham indicated that stocks with P/E ratios of
less than 15 and P/B ratios of less than 1.5 are particularly
interesting for purchase whereas stocks with higher ratios are more
speculative. There are a number of other value indicators such as a
high dividend yield which is the basis for various popular "beating
the DOW" approaches (www.fool.com).
Its all very well to talk about Mr. Market's emotions, but is it
really possible to profit from them? Graham cites a study in The
Intelligent Investor that looked at the P/E ratios of stocks in
the Dow Jones Industrial Average (DOW) between the years of 1937 and
1969 (See Table 1). In this study, the 30 DOW stocks were split into
a group of 10 low P/E stocks and 10 high P/E stocks. The low P/E
group outperformed the DOW and the high P/E group generally did
poorly. David Dreman's fascinating book Contrarian Investment
Strategies: The Next Generation picks up where Graham left off.
In his book Dreman examines the returns of the largest 1500
U.S. companies from 1970 through to 1996 when sorted by P/E, P/B &
dividend yield. To do each comparison he split the 1500 companies
into 5 equal groups (called quintiles) with group one composed of
stocks with the lowest ratios and group 5 the highest (See Table 2).
The combination of these two studies teaches that low P/E stocks, in
the U.S. outperform their higher P/E counter parts by a wide margin
and have done so over a period of nearly 60 years. Furthermore, over
the last quarter century low P/B and high dividend yield stocks have
also performed admirably.
| Period |
10 Low P/E Stocks |
10 High P/E Stocks |
All 30 DJIA Stocks |
| 1937-1942 |
-2.2 % |
-10.0 % |
-6.3 % |
| 1943-1947 |
17.3 % |
8.3 % |
14.9 % |
| 1948-1952 |
16.4 % |
4.6 % |
9.9 % |
| 1953-1957 |
20.9 % |
10.0 % |
13.7 % |
| 1958-1962 |
10.2 % |
-3.3 % |
3.6 % |
| 1963-1969 |
8.0 % |
4.6 % |
4.0 % |
| Table 1: Average Annual Percentage Movements of the DOW Sorted by P/E (1937-1969). |
| Quintile |
Price / Earnings |
Price / Book Value |
Dividend Yield |
| 1 (Low) |
19.0 % |
18.8 % |
16.1 % |
| 2 |
17.4 % |
16.3 % |
17.5 % |
| 3 |
14.6 % |
14.6 % |
15.1 % |
| 4 |
13.1 % |
13.7 % |
13.8 % |
| 5 (High) |
12.3 % |
12.0 % |
12.2 % |
| Average |
15.3 % |
15.1 % |
14.9 % |
| Table 2: Annual Return of Selected Value Strategies from January 1 1970 to December 31 1996. |
To gain some insight into the Canadian experience one can examine
some of the findings that Thomas Liston described in The
Performance of P/E Ratios in Predicting Canadian Stock Returns
(Thesis, http://members.xoom.com/tliston/essay.html). Liston looked
at stocks in the TSE 300 from 1988 to 1998 and split the stocks up
into P/E quintiles with a wrinkle. He defined an extra "quintile" for
stocks with negative P/E ratios (which I'll label quintile zero) so
that quintile one contains only stocks with low but positive P/E
ratios (See Table 3). The group of low but positive P/E stocks
outperformed the market 82.5% of the time by an average of more than
5% annually. It is heartening to know that low P/E stocks outperform
both above and below the 49th parallel. It is likely that
the international nature of value extends to low P/B and high dividend
yield stocks as well.
| P/E Quintile:
| 0
|
1 (Low) |
2 |
3 |
4 |
5 (High) |
TSE 300 |
| Annual Return |
7.33% |
7.47% |
4.98% |
4.30% |
4.18% |
4.45% |
2.22% |
| Out
Performance |
70.0% |
82.5% |
77.5% |
77.5% |
70.0% |
67.5% |
|
| Table 3: Annual Returns vs P/E quintile for the TSE 300 from 1988 to 1998. |
Conservative investors know that frequent trading can rapidly rack
up commissions and many prefer to minimize these costs. Fortunately
for value investors, Dreman has shown that frequent trading is not
necessary if you buy low P/E stocks (See Table 4). It is apparent
from this data that rebalancing a value portfolio once every few years
is more than sufficient. As a result, the value approach seems
ideally suited to the long term DRIP (Dividend ReInvestment Plan)
& SPP (Share Purchase Plan) investor.
|
Hold
Period |
| P/E Quintile |
2 Years |
3 Years |
5 Years |
8 Years |
| 1 (Low) |
18.7 % |
18.1 % |
18.7 % |
18.4 % |
| 2 |
16.9 % |
16.5 % |
17.1 % |
17.5 % |
| 3 |
15.3 % |
15.2 % |
15.5 % |
16.2 % |
| 4 |
13.5 % |
13.7 % |
14.4 % |
15.3 % |
| 5 (High) |
11.9 % |
11.3 % |
11.8 % |
12.8 % |
| Average |
15.3 % |
15.0 % |
15.6 % |
16.2 % |
| Table 4: P/E Buy-and-Hold Annual Returns from January 1 1970 to December 31 1996. |
Value strategies offer a record of superior performance and allow
for a low intensity approach to investing that saves on commissions.
Furthermore, by buying stocks with low P/E or P/B ratios the investor
enjoys a margin of safety since the earnings and assets of a going
concern with such ratios has an intrinsic value that provides support
for the stock price. As with all investment techniques, the future
performance of value investing is unknowable. However, for the
conservative investor, value investing is one of the best options for
dealing with Mr. Market.
First published in May 1999.
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