Don't Give Up On Value, But Play It Smart

8/27/2012


Value investing has a long and proud tradition. Buying stocks trading at relatively low multiples of earnings, cash flow, book value, or sales has been a winning approach over the last five, 20, 50, and 100 years. Both academics and practitioners have concluded that value investing has worked, with even diehard efficient-market proponents conceding that cheap stocks have outperformed historically.

According to data from Morningstar, large value stocks returned 10.8% annually from 1928 through 2011, versus 8.7% for large growth stocks. Small-company value stocks returned 13.9%, versus 9.0% for small growth stocks. Morningstar labels value and growth stocks based on price/book value ratios, but other valuation ratios have also proved effective.

In back-tests to 1992, the seven most effective individual variables in our Quadrix rating system are value-related metrics. The Quadrix Value score, based on more than 20 valuation ratios, has been the most effective category score in back-tests to 1992 — and in real-time use since 2000. In fact, by some measures, the Value score has been more effective than the Overall score.


TOP VALUES

----------------------- Quadrix Scores -----------------------
Sector
---- Scores ----
Company
(Price; Ticker)
Div.
Yield
(%)
Overall
Momen-
tum
Value
Quality
Fin'l
Str.
Earns.
Ests.
Perfor-
mance
12-
Factor
Sector
Reranked
Overall
Aflac ($47; AFL)
2.8
99
93
98
88
77
50
63
98
100
AGCO
($44; AGCO)
0.0
93
54
94
92
50
68
32
99
95
CF Industries
($211; CF)
0.8
100
95
90
99
92
92
89
100
100
Chevron
($112; CVX)
3.2
85
28
79
79
89
62
73
88
78
Cisco
($19; CSCO)
2.9
92
68
91
73
78
56
38
92
89
DirecTV
($52; DTV)
0.0
96
72
85
97
60
36
75
77
84
Fifth Third
($14; FITB)
2.2
92
88
80
39
90
89
80
57
93
Macy’s ($39; M)
2.0
88
68
75
72
37
73
75
93
84
UnitedHealth
($53; UNH)
1.6
92
74
82
87
56
61
33
100
94
Wells Fargo
($34; WFC)
2.6
92
76
82
52
76
83
81
90
94

Given all the evidence supporting value investing, why don’t we simply buy the cheapest stocks? And why do we consider other category scores in our Overall score? The answers to these questions overlap:

• First, strategies based exclusively on value are volatile. Our Quadrix Value score has delivered more consistent outperformance than most individual value variables — but not by much, since value variables all tend to work (and not work) at the same time.

• Second, value tends to work best in rising markets, when investors are willing to take on more risk. As a result, value-only approaches often don’t provide much protection in down markets. In back-tests, the top one-fifth of stocks in the Dow Jones U.S. Index based on Quadrix Value scores have delivered positive average returns in 76% of the rolling 12-month periods since January 1992, versus 77% for the average stock in the index and 82% for the top one-fifth on Overall score.

• Third, value-based approaches tend to be streaky. The top one-fifth of stocks based on Quadrix Value have underperformed in 25 of the last 27 rolling 12-month periods.

• Fourth, by combining valuation ratios with other stock-picking metrics, you can have the best of both worlds. With more than 80 variables in six categories, our Overall score delivers returns nearly as good as the Value score — with considerably lower volatility. For those looking to bet on a comeback for value investing, the 10 stocks on the right offer top picks

 


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