Value Investing Strategies - The Scientific Evidence
Let's take a look at the data from some of the many academic studies showing compelling evidence of excess long-term returns from basic value investing strategies. University of Chicago professors Kenneth French and Nobel Laureate Eugene F. Fama performed a survey encompassing 27 years of financial data for every stock trading on the major U.S. exchanges. All stocks in the study were divided into ten groups ranked by price/book value ratios, one of the most basic metrics used to estimate whether a company is over or undervalued with respect to the assets it owns. When you invest in a company with an extremely low price/book ratio, you're effectively acquiring ownership in the business at less than the actual dollar cost of its plants, equipment, cash reserves and other solid business assets. The companies were also divided into ten groups based on market capitalization (simply the total market value of a company's shares). The very smallest companies are almost totally neglected by Wall Street funds and analysts; as a result, careful analysis of small-cap securities with strong value characteristics can reveal deeply undervalued investment opportunities that others have neglected.
As you'll see from the table below, the results couldn't have been more clear. The low price/book ratio stocks had an incredible edge over their high price/book peers; returning on average two to four times as much per year over the study's entire 27-year time horizon. And for the most undervalued companies, a second effect became apparent : the very smallest firms, those almost completely neglected by conventional Wall Street funds and analysts, consistently outperformed by an even wider margin.
Annual Investment Returns For NYSE/AMEX/NASDAQ Listed Stocks, Ranked by Price/Book Value Ratios and Market Capitalization - July 1963 through December 1990
Proof of a significant value premium in multiple studies provides clear statistical evidence for what history has shown all along -- why the majority of mutual funds investing in overpriced glamor stocks deliver performance that consistently lags the market average, and why disciplined value investors like Warren Buffett, focused on demonstrably underpriced companies with real business value, have tended to outperform year after year. What the evidence shows about small company performance is even more compelling. Far from being outclassed by the professionals, independent investors with access to value-based strategies actually have a powerful advantage. If you start paying attention to value investing's simple, common-sense rules and begin building your own portfolio of the solid, seriously underpriced stocks neglected by the majority of investors, you'll have a better chance than any Wall Street manager at achieving investment returns that strongly surpass the market.
This simple metric is only one of several objective criteria proven by research to show important correlations with long-term returns. Nevertheless, many "quant" money managers focused blindly on screening for valuation metrics without further research have often been blindsided into investing in frauds, businesses with genuinely poor long-term economics, or businesses where one-time gains or technical accounting distortions create the superficial appearance of value. Careful attention to SEC filings can often uncover important company-specific issues that enable corrections of raw reported numbers, arriving at clearer valuation estimates that can guide investors to even greater returns than the unadjusted results described above. For example, appropriately adjusting for intangible assets and depreciation can reveal a more conservative estimate of tangible book value that is often a closer match to a company's true net worth. As seen in a number of reports from past editions of this newsletter, fundamental research can uncover assets recorded at low historical costs that are in fact worth substantially more at current prices, providing an opportunity for even stronger returns.
For over three decades, a growing body of rigorous research in quantitative finance and behavioral economics has continued to challenge traditional finance assumptions with evidence of the remarkable effectiveness of value investing strategies, and has gradually added to the power and sophistication of valuation tools available to those select few investors who actually take the time to study what has worked in the past. As demonstrated by real-world returns of successful value investors and by the track record of Deep Value research, combining the analysis of quantitative valuation ratios with careful attention to long-term business fundamentals and sustainable profitability can further outperform even these exceptional results. Literally no other investment philosophy can boast such a track record of scientifically and historically verified success.
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