Every value stock has its own story, but the common elements connecting all value stocks relate to price and risk.
Price: Value stocks are often referred to as “cheap” or “bargains” – considered by many as buying stocks on “on sale.” Value investing focuses on investing in companies where the market has discounted the stock price of the company to reflect concerns about company’s financial health.
Risk: Value companies are typically viewed as riskier than growth companies from both the perspective of the company’s underlying fundamental business characteristics and the company’s susceptibility to risk during economic cycles.
Other things being equal, the discounted price provides greater upward potential for those willing to accept the greater risk. For those investors willing to bear this additional risk, value investing has historically tended to outperform the broader market.
By comparison, growth investing focuses on investments in companies that are growing with the potential for continued growth in the future.
No single unique definition of value exists. Generally speaking, a value company’s stock has a low stock price relative to various accounting measures used to determine a company’s value, including the company’s financial accounting book value, sales, earnings and cash flows. These company attributes or “value measures” have a tendency to correlate with other numerical measures that intuitively seem risky to many investors, such as the company’s leverage, its profit margins and the variability of its financial results.
The overall impact of these various measures is heightened concern by investors about a company’s profitability, stability and survivability.
Google vs. Bank of America Corporation
Consider, for example, two well-known companies, Google and Bank of America. Google is a growth company, with a Price to Book Value (P/B) ratio of 3.4 as of April 2, 2012. This P/B ratio places its ratio in the top 75% of all U.S. publicly traded companies.
The stock price is a forward looking stock market prediction of what Google is worth. The book value is a historical accounting valuation of what Google is worth. Thus, a relatively high P/B ratio reflects a growth prediction for Google. That growth prediction correlates with many of Google’s business factors: low debt, solid earnings growth the last several years and a general consensus that it is a very successful company. Based on the P/B ratio, investors believe Google will continue to deliver strong earnings growth into the future and is a relatively lower risk company at any price. These factors make it a classic growth stock.
Bank of America (“BofA”) is a value company whose P/B ratio of 0.4 puts its ratio in the lowest 3% of publicly traded U.S. stocks as of April 2, 2012. The relatively low P/B ratio reflects the stock market thinking that BofA’s book value has future “contraction” potential. The market prices the stock in a way that calls into question its future worth.
BofA has a large amount of debt, and while its earnings grew nicely through 2007, they have vacillated substantially over the last 4 years. Further, the company is widely viewed as having made several missteps during the financial crisis of the past several years. Based on its P/B ratio, investors believe BofA is a relatively higher risk value company.
This example illustrates the basic concepts of the risk argument. Certainly Google might be riskier by some metrics; for example as a newer company some would consider it a greater risk. And not all risks may be reflected on the balance sheet. A scandal, lawsuit, management problem, accident or other surprise could affect either company. But generally the relationship between companies’ known risk characteristics and value measures holds across stock investments.
Impact of economic cycles
The value risk manifests itself most clearly through exposure to economic cycles. Historical data suggests that stock returns for value companies have been quite strong during expansions but those returns fall dramatically during recessions. As one would expect, when times get tough, companies that have greater leverage, less stable sales, or lower profitability will tend to suffer the most.
Of course trying to time one’s entry and exit to take advantage of economic cycles is very difficult – only with the benefit of hindsight can investors identify the key inflection points of economic cycles – but because recessions have been far fewer than expansions, patient value investors willing to bear greater risk for extended periods have typically been rewarded.
As it is so difficult to predict the fate of specific companies, and to time economic cycles, those seeking to take advantage of the price/risk characteristics of value stocks generally benefit from holding a bundle of them via a mutual fund or ETF, and holding it for the long term. Taken as a group over multiple economic cycles, value stock investments have typically outperformed their growth stock alternatives, rewarding investors for taking on greater risks.