You Should Care About Value Stocks....Even if you Don't Like Talking About the Stock Market

Before even talking about Value vs. Growth we need to take a step back and define what an efficient market looks like.  As a family steward I believe that the markets are efficient. Prices reflect all available information about a company.  There are millions of stock market participants every day that try to guess if a certain company is under or overvalued.  No one actually knows the true intrinsic value of the company but these market forces of all of this trading is driving the price towards some intrinsic value.  The price of the stock may not be right but it is fair. 

When you believe in the efficient market you can turn to other ways to beat the market using the scientific approach to investing.  Are there other ways to beat the market?  When looking at any research or data set you cannot bend or twist the research to fit what you believe.  In order to seriously consider research, it first must be persistent (continuing to exist for a long period of time), Pervasive (spreading widely throughout the group) and robust (strong and healthy).  We look to the Center for Research on Security Prices (CRSP) for this research.

Scientific data found four dimensions of return that pass this test in the stock market.  Academic research has identified these dimensions, which are well documented in markets around the world and across different time periods.

 These four are the equity premium, value premium, size premium and profitability premium.  Today we are going to talk about the value premium and how to capture this premium to potentially add value to your portfolio.

First – what the heck is the value premium?  The value premium means that over the long run value stocks outperform growth stocks. 

What is a value stock?  Value stocks are those that generally have fallen out of favor in the marketplace and are considered bargain-priced compared with book value, replacement value, or liquidation value. Typically, value stocks are priced much lower than stocks of similar companies in the same industry. This lower price may reflect investor reaction to recent company problems, such as disappointing earnings, negative publicity, or legal problems, all of which may raise doubts about the companies' long-term prospects.

The primary measures used to define growth and value stocks are the price-to-earnings ratio (the price of a stock divided by the current year's earnings per share) and the price-to-book ratio (share price divided by book value per share). Growth stocks usually have high price-to-earnings and price-to-book ratios, which means that these stocks are relatively high-priced in comparison with the companies' net asset values. In contrast, value stocks have relatively low price-to-earnings and price-to-book ratios.

If you had a choice to go work for a growth company or a value company, you would probably want to work for the growth company.  Think of Apple as a growth company.  However, if you were to go buy a stock on the stock market you may rather own a value stock to capture the premium.

How do you know if it is a value stock?  I use the price to book ratio to measure whether a particular company is a growth or value company.

The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market price to its book value.  The calculation can be performed in two ways, but the result should be the same each way. In the first way, the company's market capitalization can be divided by the company's total book value from its balance sheet. A balance sheet is a Statement of financial condition or a snapshot of a company’s health.  If the company needed to liquidate what would the company, be worth.

What is market capitalization?  Market capitalization (market cap) is the total market value of the shares outstanding of a publicly traded company; it is equal to the share price times the number of shares outstanding.

Click to View Value companies as a group compared to growth stocks.