The Mechanics of Value Investing

di Max Malandra 25 Aprile 2019 | 13:00

A cura di Jack Forehand, Validea Capital Management

We all have a tendency to want to put investing strategies into groups. That can sometimes be misleading, though. There are more investment products than I can count that use the word value in their name. But beneath the surface, many of those products couldn’t be any more different. Those differences can lead to substantially different outcomes in both the long- and short-term, so it is very important to understand the investment process and parameters used to create any value portfolio before you invest in it. Since I often discuss value investing in my articles, I thought it might be helpful to take a step back and take a look at some of the important details to consider when building or analyzing any value strategy.

Defining Value

But first, I think it is important to define value. When I look at strategies that are referred to as value, I break them down into three distinct categories.

[1] Ben Graham Value – This group of strategies focuses on buying the cheapest stocks. They can use very different metrics to get there, but the end result is a group of companies that are cheap and out of favor. When we talk about the academic research into value investing, this is the group we are talking about. Most academic work will focus on buying the bottom decile (or cheapest 10%) of stocks.

[2] Warren Buffett Value – This group combines value with some sort of measure of quality. The goal is not to buy the cheapest stocks, but rather to buy good companies that are trading at a discount to some measure of their intrinsic value with the hope that the profits these firms make will compound over time. These types of approaches generally end up with more expensive stocks (vs the Graham style above) and stray further away from the academic definition of value.

[3] Bill Miller Value – This style was popularized by Miller in the 90s when he argued that many tech companies were value investments despite the fact that they were very expensive by any traditional value metric. The argument proponents of this type of approach will make is that if you look at companies as the present value of expected future cash flows, then companies with strong projected future growth can be cheap today, even if they trade at high multiples based on things like sales and earnings. These types of strategies stray the furthest from the academic definition of value (they actually have almost nothing in common with it at all).

When I use the term value, I am always referring to the academic definition (#1 above) and mostly discussing it in the context of systematic value models, but you will see the term used in varying ways so I think it is important to establish a clear definition first.

Once you define value, you then need to make a series of important decisions to take that concept and express it as an actual investment portfolio. Here are a few of the most important things that go into the recipe of building a value strategy and what to keep your eye on for each of them.

The Process of Building a Value Portfolio

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