The Great Depression, which lasted almost four years, from August 1929 to March 1933, marked the threshold of what today is called “value investing.” That may seem strange because investors have been deploying their capital for centuries in pursuit of value. Therefore, value investing is nothing new. What is new is the approach and analysis undertaken to determine what investments may yield value or not. This was the subject of a lengthy tome titled Security Analysis penned by two professors at Columbia University’s Business School in 1934. The authors were Benjamin Graham, an investment fund manager and lecturer in finance, and David Dodd, who was an associate professor of finance.
That classic text proposes a number of investment strategies.
Purchasing Stocks with a Low Price in Relation to Asset Value
Asset value is measured mainly in two ways: book value and market value. The book value of an asset is the value at which the asset was “booked” into the accounts, usually the purchase price of the asset. For example, the current book value of land purchased 20 years ago would be the price paid then, unless the land has been revalued at some different price. However, for some other assets, book value includes depreciation. For example, residential buildings are generally depreciated over a 27.5-year life, while commercial buildings are depreciated over a 39-year period. That means, on average, the value of a residential building decreases by 3.636% every year and the value of a commercial building decreases by 2.564% every year. Note, however, that the Job Creation and Worker Assistance Act (2002) and the Tax Cut and Jobs Act (2017) allowed faster rates of depreciation. This was to allow the cost of capital to be recovered more quickly in order to stimulate economic activity. A business thus has a choice of depreciation methods to choose from. According to its book value—the book value of its assets less the book value of its liabilities—is not as objective as it first appears. The book value of a business is its accountant’s opinion of the business’ value.
But investors also have an opinion about the firm’s value. This is reflected in the firm’s market value. The market value or market capitalization of a business is the value of all its outstanding shares. A business with 100,000 outstanding shares trading at $50 has a market value of $5 million. It’s unlikely that book value and market value will be the same. Internal (accountants and management) and external observers (creditors and investors) are likely to have a different opinion about what the business is worth.
Most successful firms have a market value greater than their book value. This shows that the firm has created value. It has taken net assets, i.e., total assets minus liabilities, and used them in a way that makes them worth more. But suppose the market value is less than the book value, i.e., the share price has fallen. Very often, that’s because the company’s prospects are grim. The market value of a firm is, after all, the discounted present value of future cash flows. But it’s possible that there may indeed be firms that the market is mispricing. And there is evidence to back this up: low price to book ratio stocks have historically earned much higher returns than the rest of the market.
Low Price by Earnings
Stocks bought at lower price/earnings ratios also provide greater earnings yields than stocks bought at higher price/earnings ratios. The price/earnings ratio compares the price of a company’s stock to its earnings. It can be viewed as the price one has to pay for $1 of a company’s profits. If a company has earnings per share of $3 and the share price is $45, the PE ratio is 15. The current PE ratio of the S&P 500 is 40.12 but as an average that PE must be used with caution.
The same applies to the PE of a particular firm. A low PE may signal a bargain, if the company’s profits will improve. Otherwise, a low PE may be a sign a company is heading for bankruptcy.
Observing Purchases by Insiders
Generally, insiders are officers, directors and shareholders that are privy to information that has not been made public. If they buy or sell the company’s shares before that information is disclosed to the public so as to gain an advantage, they will be guilty of illegal insider trading. Not all insider trading is illegal, however. Insiders are not prohibited from trading in their firm’s shares. They must simply disclose such trading and time it in a way that does not capitalize on having a “heads-up.” Additionally, if they buy and sell, or sell and buy the firm’s shares within a six-month period, they could be liable for receiving short-swing profits.
Nevertheless, if insiders, particularly management, are buying the company’s shares, it indicates they have confidence in the company’s future. Unless, they have a dubious reputation, this may be an opportunity to free-ride. Free-riding occurs when people who did not pay for information use that information. There’s no law against such activity, i.e. buying or selling shares if someone else does. If it’s an insider’s trades that are being copied, it may, in fact, be the right thing to do.
Information contained in this publication has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by MRG Wealth Management Inc., or any other person or business as to its accuracy, completeness, or correctness. Nothing in this publication constitutes legal, accounting or tax advice or individually tailored investment advice. This material is prepared for general circulation and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. This is not an offer to sell or a solicitation of an offer to buy any securities.