High-flying technology firms, trendy retailers pitching the latest "must-have" products, companies from the fastest-growing emerging markets - as an investor, it's easy to be drawn to the stocks of "glamour" businesses like these.
History, however, has shown that investors fare better by focusing on much less glamorous stocks. In fact, numerous studies show that investing in overlooked value stocks generates better long-term returns than investing in popular, high-flying growth stocks.
Why is that? David Dreman, the Canada-born contrarian guru upon whom I base one of my investment models, wrote several years ago that investor expectations were a key reason. Now, a new study from the Brandes Institute builds off of his research.
While many have assumed that value stocks outperform because they come with higher levels of risk, Brandes found otherwise. It examined how value stocks (which it defined as those with lower price/earnings ratios, using projected earnings for the next year) and "glamour" stocks (those with higher forward-looking P/Es) fared after beating or missing earnings expectations.
Its findings: "Prices rose for value stocks when they exceeded (or beat) earnings forecasts and, perhaps counterintuitively, when they missed expectations." More popular glamour stocks, meanwhile, produced lower returns whether they beat or missed expectations, and, importantly, the trend held up regardless of whether the firm's business was improving or declining.
That, Brandes concludes, shows value stocks outperform not because they are riskier, but instead because of behavioural biases that cause investors to put unrealistically high expectations on glamour stocks, and unrealistically low expectations on value stocks. "Over time," the group says, "as the influence of these biases weaken, security prices revert away from extreme levels." That means value investors who stay disciplined and rational can take advantage of opportunities caused by those unrealistic expectations.
These findings wouldn't be surprising to many of history's best investors. In fact, many of the greats upon whom I base my Guru Strategies were value investors who were well aware of the inefficiencies - and opportunities - that investors' emotions and expectations create in the market. While Brandes' study identified overlooked value plays by using P/E ratios, the gurus did so using a variety of different valuation metrics. (Each also used a variety of other variables, such as debt metrics and earnings and sales growth figures, to make sure a firm had both cheap shares and a good business.)
To see how different gurus used different valuation metrics to identify overlooked value stocks, I have identified a few firms some of my value strategies are high on.
Carlisle Companies Inc. : This North Carolina-based manufacturer has clients in a number of unglamorous industries, such as construction materials, commercial roofing and specialty tires. It's a favourite of the strategy I base on the writings of Benjamin Graham, renowned as the father of value investing.
Mr. Graham was well aware of the impact that expectations had on value and glamour stocks. Good value stocks, he found, offered a "margin of safety" - that is, they traded at such low levels compared to the real value of their businesses that they didn't have much further to fall if bad news hit. To find value stocks, he used two different P/E ratios. One used a firm's trailing 12-month (TTM) earnings per share and the other used average three-year earnings. This strategy requires the higher of the two to be no greater than 15. Carlisle's P/Es are 11.2 (three-year) and 12.5 (TTM), so it passes the test.
Mr. Graham also used the price/book ratio, employing an interesting standard: The product of a firm's P/E (using the greater of the two P/Es referenced above) and its price/book ratio should be no greater than 22. Carlisle's price/book ratio is 1.41. When we multiply that by its 12.5 P/E, we get a product of 17.6, which makes the grade.
Other reasons my Graham approach likes Carlisle? It has more than three times as much net current assets as long-term debt, and a 2.56 current ratio.
Eli Lilly & Co. : Based in Indiana, this big pharma firm gets high marks from my David Dreman-based contrarian strategy. In looking for deep value contrarian picks, Mr. Dreman used four different value metrics: the P/E, price/book, price/cash flow and price/dividend ratios. This model requires a firm to be in the market's bottom 20 per cent in at least two of those categories to be a bona fide contrarian play. Lilly's low P/E (using TTM EPS) and price/dividend ratios fit the bill.
The Dreman approach also likes the fact that Lilly has a 1.97 current ratio, 47.4 per cent return on equity, and a total debt/equity ratio about half its industry average.
Reinsurance Group of America : This Missouri-based firm is one of the largest reinsurers in the world. It's also a favourite of the model I base on the writings of mutual fund great John Neff.
The Neff approach targets stocks with P/E ratios that are between 40 per cent and 60 per cent of the market average, using TTM EPS. (Mr. Neff found that P/Es lower than 40 per cent of the market average were a sign that the firm was simply a dog, and that everyone knew it.) The current market P/E is 15, so RGA's 7.23 P/E falls neatly into that 40 to 60 per cent range.
Mr. Neff also developed another metric to find strong value stocks: the "total return/PE ratio." This adds a stock's EPS growth and dividend yield together, and divides the result by the stock's P/E. The result should be at least twice the market average, or twice a firm's industry average. RGA has a long-term EPS growth rate of 8 per cent (using an average of the three-, four-, and five-year rates), a dividend yield of 1 per cent, and a 7.23 P/E. That makes for a total return/PE of 1.25, which is more than twice the market average (0.58).
Full disclosure: I own shares in Carlisle Companies and Eli Lilly.