Study On The Birth Of Value Investing Finance Essay - Free Essay Example

Sample details Pages: 21 Words: 6397 Downloads: 1 Date added: 2017/06/26 Category Finance Essay Type Research paper Did you like this example? Benjamin Graham is considered the father of security analysis and value investing. He denied the common belief that value and price were synonyms as Graham argued that price is what is paid for the security, and value is what is received. In Security Analysis, Graham and Dodd emphasized that price and value did not necessarily gravitate together all the time as they observed at times that value and price would diverge. Don’t waste time! Our writers will create an original "Study On The Birth Of Value Investing Finance Essay" essay for you Create order Benjamin Graham and David Dodd argued that stocks which became out of favor would ultimately become underpriced in the marketplace, and investors who were aware of this phenomenon could capture strong returns by holding the security the marketplace recognized its true worth. The duo suggested that widely popular securities would trade at premium, often led by high expectations, and became risky as trend chasers drove the prices up without coherent backing for their expectations. Graham defies the logic of efficient market hypothesis as he argues that the stock market is an irrational place where investors overreact and tend to simply follow the crowd. According to Graham and Dodd, the ideal investor would not blindly follow the crowd, rather, they are disciplined whereby they seek out securities selling for less than their intrinsic value and then wait for the market to recognize and correct the disparity. In 1949, Benjamin Graham released his new book, The Intelligent Investor , which the legendary investor Warren Buffett described as the greatest book about investing ever written. Within this book, Graham describes that the market will overvalue companies that show growth or are very popular in the media whilst the market will undervalue firms that are out of favor for some reason. The market contains stocks whose price will rarely equal the investors estimate of its value. However given time, the market will correct itself where the stocks price and value will eventually converge. Following this principle we find that under certain conditions, a security may be purchased below its intrinsic value; and the greater the discrepancy the greater the margin of safety. There are several equity-portfolio managers that place themselves in the value or growth camp. Growth camps are stocks from firms that enjoy above-average earnings-per-share increases and usually have above average price to book and price to earnings ratio. Value camps, on the other hand, cha racterize themselves as value funds as they only invest in stocks with low price earnings ratio or low price to book value ratio, relative to the market. Damodaran emphasizes that this is a narrow definition of value investing and misses the essence of value investing. Another convention for value investing provides that value investors are interested in buying securities below their intrinsic value. However, Damodaran describes this definition as too broad and underscores that growth investors would also like to purchase securities below their true worth. He highlights that the true essence of value investing derives from the assets that are already in place, expected future investments and growth opportunities. Thus, value investors desire to purchase securities for firms for less than what their assets in place are worth. Damodaran underlines that value investing branches out into three unique segments. The first form of value investing is passive screening where companies are selected using relatively simple criteria which includes relative valuation multiples (earnings multiple, book value, revenue multiples, etc). The second form is a relatively new phenomenon known as contrarian value investing where one buys neglected securities due to poor historical performance or lack of media coverage. In the third form, you become an activist value investor whereby you purchase equity from poorly managed firms but you then use your position to turn the company around (assuming that you purchase enough equity to give you that role). For this paper, I am going to focus on the first two aspects of value investing. In 1934s Security Analysis, Benjamin Graham and David Dodd provide their readers with specific screen to find value stocks, summarized below: An earnings-to-price yield at least twice the AAA bond yield. A price-earnings ratio less than 40 percent of the highest price-earnings ratio the stock had over the past five years. A dividend yield of at least two-thirds the AAA bond yield. Stock price below two-thirds of tangible book value per share. Stock price two-thirds net current asset value. Total debt less than book value. Current ratio greater than two. Total debt less than twice net current asset value. Earnings growth of prior ten years at least 7 percent on an annual basis. Stability of growth of earnings in that no more than two declines of 5 percent or more in the prior 10 years. Graham would recommend purchasing the security if it passed all of the criteria given above. Henry Oppenheimer studied the portfolios obtained from these screens from 1974 to 1981 and concluded that you could have made an annual return well in excess of the market. The screening process has evolved over the period and many research studies have been carried out to test their validity. The purpose of this paper is to review literatures that have studied the styles involved in value investment strategies and how it compares with its competitor, growth investment strategy. Furthermore, this paper will also examine the evolution of Grahams investment strategy and try to highlight that value and growth camps may not be as mutually exclusive as it is widely known to be. The principle behind this paper is not to prove that value investment strategy in the best technique for security selection, rather it is to analyze objectively the method involved in selecting securities under the umbrella of value investment strategies, and how it contributes to an investment portfolio. Relative Valuation multiple Benjamin Grahams Net Current Asset Value Stock Selection Criterion The net current asset investment selection criterion, developed by Benjamin Graham, seeks out securities which are priced at 66% or less of a companys underlying current assets (cash, receivables and inventory) net of all liabilities and claims (current liabilities, long-term debt, preferred stock, unfunded pension liabilities). Graham highlighted that he used the net current asset investment selection technique extensively while he was managing the Graham-Newman Corporation and reported that the average return over a 30-year period, on diversified portfolios of net current asset stock was approximately 20% per year  [1]  . Oppenheimer (1986) examined the investment results of stocks selling at or below 66% of net current asset value during the 13-year period from 1970 through 1983. The portfolio was rebalanced annually and he selected companies from the New York Stock Exchange (NYSE), the American Stock E xchange (AMEX), and the over-the-counter securities market. The minimum number of securities that a portfolio held was 18 and the maximum was 89 stocks. Oppenheimer found that the mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index. However, the results were not consistent as data showed that between 1970 and 1973, the mean annual return from the net current asset portfolio was 0.6% per year as compared to 4.6% per year for both the exchanges. Moreover, the study compared the investment results from the net current asset firm which operated at a loss as compared to firms which operated profitably. The study found that companies operating at a loss had slightly higher investment returns (31.3%) than the companies with positive earnings (28.9%). Book Value Multiple Damodaran highlights that the book value of equity is the value of equity in a firm from an accounting perspective, while the market value of equity is the value of a firm determined by investors. Some investors argue that low price to book stocks are value stocks and high price to book stocks are growth stocks. Investors have used these competing criteria as a method for stock selection and several studies have been carried that examined the returns generated by the two respective strategies. Fama and French (1992) carried out a classic study on the performance of low price to book value stocks over a 27 year period from 1963-1990. The stocks were selected from several indexes including the NYSE, AMEX and NASDAQ. Fama and French divided the securities into ten groups according to their price to book value and they were re-ranked anually. They found that the lowest price to book portfolio (value) outperformed the highest book-to-market portfolio (growth). They found that the value portfolio generated an average return of 24.31 percent a year, while the growth portfolio of 3.7 percent from 1963-1990. Banz (1981) argu es that value portfolios with high book/market tend to consist of firms smaller in size than portfolios with growth stocks. He highlights that part of the book-to-market effect may reflect the premiums that small firms tend to have over larger sized firms. Furthermore, systematic risk could not explain the differences in the portfolio since the market beta for both portfolios were similar. Fama and French argued that value represented a risk factor that investors were being compensated for taking on additional risk. Several studies of foreign stock markets have developed similar findings regarding growth and value stocks. This implies that investors worldwide systematically misprice value stocks. For example Chan, Hamao, and Lakonishok (1991) examined the relationship between the average returns on Japanese stocks and their value of B/M ratio, E/P ratio, and C/P ratio, and size. They formed four equally weighted portfolios that were re-ranked annually and one special group for st ocks that have negative values for the scaled price variables. They found that firms with the highest E/P, B/M, C/P (value stocks) had the greatest investment returns with each portfolio performing better than one below. The greatest difference in average returns was found under the book to market ratio, where the high book to market portfolio (value portfolio) earned approxiamtely 29.16% per year and the lowest book to market portfolio (growth portfolio) earned 15.96% per year. Furthermore, companies with high book to market value seemed to be firms with high cash flow to price and earning to price which implied that the different measures of value were correlated. This is further supported by Capaul, Rowley, and Sharpe (1993) who extended the analysis of price-book value across the international market as they studied six countries from January 1981 through June 1992 and determined that value stocks outperformed growth stocks on average in each country. Earnings Multiple Gra ham argued that stocks with low price to earnings ratio are more likely to be undervalued and have the possibility to earn excess returns. Several studies have studied relationships between PE ratios and excess returns and have consistently found that low P/E stocks tend to outperform the market and high P/E stocks. In What Works on Wall Street, OShaughnessy found that the P/E ratio is particularly relevant with large stocks. However, one should recognize that securities that are priced at discount relative to their earnings do not precede securities that have high expected earnings growth rate. Value strategists argue that a firms with a low price to earnings value combined with expected earnings growth rate are superior than firms with simply a low price to earnings value. Oppenheimer (1984) examined the investment performance of low P/E ratio stock (as developed by Benjamin Graham) and investment returns. One of Grahams stock selection criteria as highlighted above included th e purchase of securities of companies in which the earnings yield was at least as twice as the AAA bong yield and the companys total debt was less than its book value. Oppenheimer found that Grahams selection criteria achieved a mean annual return exceeded the market index of 38 percent 14 percent, from 1974 to 1980. Several other analysts including Basu (1977) examined the relationship between P/E and excess return from 1957 through 1971. He found that the average annual rate of return for lowest P/E portfolio was 16.3% while the average annual rate of return for the highest P/E portfolio was 9.3%. Furthermore, Damodaran studied the relationship between 1952 and 2001 and found that firms in the lowest P/E ratio (value) class earned 10% more each year than the stocks in the highest P/E class (growth) between 1952 and 1971, about 9% more each year between 1971 and 1990 and about 12% more each year between 1991 and 2001. He further determined that the excess return earned by low P/ E ratio stocks was also true in the international market. The findings for the international market are further supported by Chisholm (1991) who examined price-to-earnings ratio and investment returns in the United Kingdom, France, Germany, and Japan. He found that the lowest price/earnings portfolio outperformed the highest price/earnings portfolio in all of the countries from 1974 through 1989. Furthermore, an interesting study was carried out by Goodman and Peavy III in their book, Hyper-Profits, where they investigated annual investment returns of companies priced low in relation to earnings relative to other companies in the same industry between 1962 and 1980. They found that stocks with the lowest price-to-earnings value relative to other companies in the industry earned an annual investment return of 23.61% while stocks with the highest price-to-earnings value relative to other companies in the industry earned an annual investment return of 5.42%. Other earnings multip le include price to cash flow whereby the cash flow is measured as earnings plus depreciation. Keppler (1991) examined the relationship between price to cash flow and investment returns for firms throughout the world (Australia, Austria, Belgium, Canada, Denmark, France, Germany, Hong Kong, Italy, Japan, The Netherlands, Norway, Singapore/Malaysia, Spain, Sweden, Switzerland, the United Kingdom, and the United States). Between 1970 and 1989, Keppler created an equally weighted portfolio (according to the ratio of price to cash flow) each quarter following eighteen Morgan Stanley Capital International national equity indexes. Cash flow was determined as cash flow plus depreciation and net earnings after tax, dividends on preferred stock, minority interest, and distributions to employees. The study found that an investment in the lowest price to cash flow portfolio produced a 19.17% compound annual return in local currencies over the nineteen years and eleven months. On the other h and, investment in the highest price to cash flow portfolio provided a 4.37% compound annual return in local currencies. Revenue Multiple Damodaran argues that an increasing numbers of investors examine the top half of the income statement due to lack of transparency in accounting earnings, because these numbers are less susceptible to accounting manipulation. Several studies have concluded that stocks with low price to sales ratios outperform the market and stocks with high price to sales ratios. In What Works on Wall Street, James P. OShaughnessy determined that price to sales value is the strongest influential factor of excess returns. Senchack and Martin (1987) examined the performance of low price to sales ratio portfolios with low price-earnings ratio portfolios, and concluded that the low price-sales portfolio outperformed the market but not the low price-earnings ratio portfolio. They also found that the low price-earnings ratio strategy earned more consistent returns than a low price-sales ratio strategy, and that a low price-sales ratio strategy was more biased towards picking smaller firms. Further research was carried by Jacobs and Levy in 1988 who concluded that low price to sales ratio alone provided excess return of about 2% a year between 1978 and 1986. They further underlined that price to sales ratio became a significant determinant for excess return even when other factors were taken into consideration including size, PE, P/BV, earnings momentum measures, relative strength and neglect. Dividends Yield Some investors like to receive dividends payments and prefer stocks with high dividends yield than low dividends yield. McQueen, Shields, and Thorley (1997) analyzed the Dow dividend strategy which consisted of buying the 10 highest yielding Dow stocks from 1946 to 1995. Proponents of the strategy claimed that investing in the Dow Dogs could generate excess returns in comparison to the Dow 30 and SP 500. However, McQueen et al found that the Dow-10 produced significant excess returns over the 50 year period. The average annual return for the Dow-10 was 16.77% versus 13.71% for the Dow-30. However, higher risk as measured by standard deviation (19.10% versus 16.64%) accompanied the higher returns as a portfolio of 10 stocks is likely to have a substantial amount of firm specific risk. The authors determine that most of the Dow-10 returns come from dividends which cannot be deferred and are taxable. Moreover, the Dow-10 strategy requires annual rebalancing exposing further transactions costs and taxable income on capital gain. They conclude that while the raw returns from buying the top dividend paying stocks is higher than the rest of the index, adjusting for risk and taxes eliminates all of the excess return. A study by Hirschey in 2000 also indicates that there are no excess returns from this strategy after you adjust for risk. Damodaran highlights three implications for a high-dividend strategy. The fi rst implication that one needs to take into consideration is dividends are exposable to taxable income and are taxed at a higher rate than capital gains. The second implication that one needs to be aware of is that a firm will not necessarily continue to pay high dividends forever as they may be paying out more than they can afford or more than they should. This leads us to the third implication which emphasizes that a high dividend payout ratio means that the firm is not reinvesting its earning back into the firms which therefore indicates that there is very little growth opportunity for the firm. Further Retrospective on Value Investment Strategies The financial industry has long been exchanging ideas between different investment strategies. The topic of value and growth investing styles has long been evaluated by academics. Results from academic studies have formed the foundation for investments strategies that have been widely applied in the financial markets. Some of the earlier studies that examined the different investment strategies were Fama and French (1992) that we looked at above, and Lakonishok, Shleifer and Vishny (1994). Fama and Frenchs research brought the Capital Asset Pricing Model under scrutiny as they found that beta does not explain the cross section of stock returns from 1963 to 1990. This study found that that the ratio of book-to-market value of equity and the size of the firms provided a better explanation for the cross-section of average stock returns. Lakonishok, Shleifer and Vishny (1994) tried to take account of the size effect and they found that the average size-adjusted return over the fi ve post-formation years for the value portfolio is 3.5 percent compared to -4.3 percent for the growth portfolio. Thus, the relative size of the firm cannot alone explain the effect of the book-to-market ratio. LSV evaluated the performance of several value strategies including book to market (B/M), cash flow to price (C/P), earnings to price (E/P), growth of sales (GS) and multi-dimensional measures of value. LSV found that performance for glamour stocks was outpaced by performance for their value counterparts. The C/P strategy had the biggest difference return of about 11% per year. LSV further determined that value strategies built with two value measures outperform those using only one variable. One can argue that the findings are the result of data-snooping which means that the success of value strategies should not hold up in other periods or other markets. However, Chan, Hamao, and Lakonishok (1992) found a strong value premium in the Japanese market. Moreover, Brouwer (19 96) confirmed the outperformance of value strategies in the European market (France, Germany, Netherlands, and the United Kingdom). This eliminates the effect of data-mining as the findings are similar in two markets with very different conditions. This was supported by Sanders (1995) who studied six countries from 1980 through 1993 and found that on average value portfolio outperformed growth portfolio. Furthermore, Chisolm (1991) studied stocks in France, Germany, Japan and the United Kingdom from 1974 through 1989. Stocks were divided into quintiles based on price to book value and adjusted annually. In each country the low price to book value quintile outperformed. The difference in annual compound returns in France and Japan was more than 10% for the period studied. Chisolm also divided stocks into quintiles based on P/E and found similar results with low P/E stocks outperforming, particular in the United Kingdom. Value versus Growth strategies Chan and Josef Lakonishok ( 2004) reviewed and updated the literature regarding the performance of value versus growth strategies through 2001 and provided some new results based on an updated and expanded sample. They found that even after taking into account the experience of the technology led stock markets of the late 1990s, value stocks generated superior returns. Chan and Lakonishok constructed large cap and small portfolios by sorting stocks on a composite value indicator (book-to-market value of equity, cash flow relative to price, earnings yield and the sales to price ratio). The composite indicator allowed them to identify stocks that were undervalued relative to their fundamentals. From 1971 to 2001, the geometric mean return on the value portfolio for large stocks was 20.4 percent in comparison to the return generated by the Russell 1000 value index of 15.4 percent which indicated that the use of multiple measures in the composite indicator boosts the performance of the value strategy. Yet ag ain the small cap portfolio, the deep value portfolio outperformed the Russell 2000 value index. In the large cap study, the return differential between the average returns for the top two deciles (growth) and the bottom two deciles (value) was 10.4 per cent in favor of the value stocks. The gap was even more pronounced in the small cap study where the value deciles outperformed the growth deciles by 18.8 percent over the period. Explaining the performance of value strategies The academic community in general have found that value investment strategy tend to outperform growth investment strategy. However, academics have provided different reasons for the superior return for value stocks versus growth stocks. Fama and French support the efficient market hypothesis theory and underline that the higher returns for value stocks are a result of greater risk. In other words, the value premium is simply a compensation for bearing the extra risk. On the other hand, DeBondt and Thal er (1985) and Haugen (1995), emphasize that value premium arise from mispricing when contrarian investors profit by shorting stocks and naive investors overreact due to misplaced enthusiasm (i.e. growth stocks) and by buying stocks that are out of favor (i.e. value stocks). Fama and French (1992) argue that the superior returns of value strategies can be attributed to higher risk. High book- to- market stocks tend to bear higher fundamental risk and their higher returns are simply a compensation for that risk. However, Lakonishok, Shleifer and Vishny (1994) argue that risk does not explain the difference in returns. They emphasize that if risk were to explain the difference in returns then value stocks should underperform during bad states of the world when the marginal wealth of the world is high, such as extreme downturn in the market or economic recessions. Chan and Lakonishok (2002) who reviewed the study summarized the results from Contrarian Investment, Extrapolation, and R isk study. They isolate 25 months with the worst stock market performance, the other 88 months with negative market returns remaining after the worst 25, the 122 months with positive market returns excluding the best 25, and the 25 months with the best market performance. During the worst 25 months, the value portfolio outperformed the growth portfolio by 1.8 percent. Additionally, the value stocks outperformed the growth stock by 1.4 percent on average during negative market returns. During good states, value portfolio seemed to fare better than the growth portfolio. Thus, there were no significant evidence found that supported the notion that superior returns on value stocks reflect higher risk. The risk factor is further undermined by a study carried out by Abhyankar, Ho, and Zhao (2006) who investigated the value versus growth strategies based on stochastic dominance. Using half century of U.S. data, they tested for stochastic dominance relations between return distributions of investments in value between return distributions of investment in and value and growth portfolios. They emphasized that the advantage of using this approach is that it does not require the use of any specific asset pricing model to correct for risk and minimal assumptions were required about the return distributions and investor risk preference. Moreover, this approach allowed one to compare the entire distributions of portfolios rather than only the mean or median returns. They found strong evidence that value portfolios stochastically dominate growth portfolios in all three-order of stochastic dominance relations from 1951 to 2003, including during good economic periods. However, they determined that there is no significant stochastic dominance relation between value and growth stocks during recessionary periods, which is inconsistent with the risk based predictions that value stocks underperform growth stocks when the marginal utility of wealth is high. Thus, it may be better explained by behavioral models. Lakonishok et al. (1994) underscore that value strategy may produce higher returns because they are contrarian to naÃÆ'ƒÂ ¯ve strategies followed by other investors. These naÃÆ'ƒÂ ¯ve strategies include extrapolating past high abnormal returns into the future, investors expect future growth to be connected to past growth, overreact to good or bad news, equating good investment with a well run company irrespective of price. Shefrin and Statman (1995) support the behavioral asset pricing theory which argues that noise traders make cognitive errors that lead to the belief that good stocks are stocks of good companies. Therefore, these investors prefer glamour strategies (growth stocks) over value strategies (value stocks). Information traders, such as money managers of investment or pension funds follow this behavior. The reason for this is that they also have a preference for glamour strategies, because their clients are more f orgiving of losses on stocks of good companies than of losses on stocks of bad companies. Lakonishok et al. (1994) support the claim as they argue that institutional investors may prefer glamour stocks because they appear to be prudent investments, and hence are easy to justify to sponsors. Chan and Lakonishok (2002) emphasize that value stocks tend to have a past history of poor performance with respect to growth in earnings, cash flow and sales. Conversely, glamour stocks have out-shone their value counterparts in terms of past growth. Chan, Karceski and Lakonishok (2002) highlight that investors and analysts overlook the lack of persistence in growth rate and instead project historical growth rates into the future, thus creating favorability towards glamour stocks because they are easier to justify to sponsors. These stocks receive tend receive huge media coverage followed by significant number of financial analysts. Thus, money managers may feel compelled to hold glamour port folios which cause value stocks to be under-priced and glamour stocks to be over-priced. Shleifer and Vishny (1997) argue that the limitation on arbitrage causes the mispricing pattern to persist over long periods of time. Is value and growth mutually exclusive? Several studies classify stocks simply based on relative valuation multiple in order to place them in two different camps, value and growth. However, Ahmed and Nanda (2000) argue that the traditional method of classifying securities ignores situations where value and growth investing strategies can actually complement each other instead of being classified as mutually exclusive in order to produce superior returns. Ahmed and Nanda emphasize that growth in EPS may yield to be better characteristic of growth than simply using a high price to earnings ratio. A strategy that seeks out securities with dual characteristics of a low price to earnings ratio and a high growth rate in EPS will outperform a strategy that simply s eeks out low price to earnings stocks. They defined growth stocks as those having a high growth rate in historical EPS and evaluate the returns to portfolio that lie at the intersection of value and growth styles. They used two-year average growth rate in EPS of securities from the NYSE and NASDA. They found that stocks at the intersection of high earnings yield and growth outperform all other stocks from 1982 to 1997. The highest earnings yield with the highest growth rate generated an average return of 15.20% while the lowest earnings yield with the highest growth rate generated an average investment return of 9.26%. A $100 investment in the highest earning yield with growth characteristics in 1982 would have increased to $1,489 by 1982. On the other hand, a similar investment in the lowest earning yield with growth characteristics in 1982 would have increased to $226 by 1982. They further determine that a high earnings yield portfolio with growth characteristics outperformed t he Wilshire 5000 value index. However, Ahmed and Nanda indicate that an investor will have to rebalance their portfolio every year if they want to achieve superior results from investing in high earnings yield and growth stocks, which can lead to significant transaction costs. Though, they argue that the performance of high earnings yield and growth stocks persisted in the second year without rebalancing. Contrarian Value Investment strategy The second strand for value investments includes the contrarian value investing style. Within the realm of contrarian investment style, the central thesis is that markets overreact to new information and systematically over price stocks when the news is good and under price stocks when the news is bad. There is some evidence that suggests that markets do overreact to both good and bad news, especially in the long term, and that stocks that have done exceptionally well or badly in a period tend to reverse course in the following period, but only if the period is defined in terms of years rather than weeks or months. To isolate the effect of price reversals on the extreme portfolios, DeBondt and Thaler constructed a portfolio of 35 best performing and 35 worst performing stocks over the preceding five years from 1933 to 1978. The average price decline was 45% for the loser portfolio. They examined returns on these portfolios for the sixty months following the creation of the portf olio. The study indicates that an investor who bought the 35 worst performing stocks and held it for five years would have generated a cumulative abnormal return of 30% over the market index and 40% over the 35 best performing stocks. DeBondt and Thaler also tested portfolios of worst and best performing stocks based on investment returns over the prior three years and found similar significant excess positive returns for the worst performing stocks and similar below market returns for the best performing stocks. Damodaran highlights that many academics and practitioners provide an insight for the findings and emphasize that they may overstate potential returns for loser portfolio. For example, Damodaran argues that there is evidence for loser portfolios to most likely to contain low priced stocks (selling for less than $5) which are more likely to generate skewed returns, i.e., the excess returns come from a few stocks making phenomenal returns rather than from consistent perfor mance. Moreover, Zarowin (1990) found that when you do not control for firm size, the loser stocks outperform the winner stocks, but when you match losers and winners of comparable market value, the only month in which the loser stocks outperform the winner stocks is January. One final point that Damodaran underlines is that even though there may be evidence of price reversals in the long period, there is evidence of price momentum as loser stocks will continue to produce negative returns and winner stocks will continue to generate higher returns in the short run (6 months to a year). This is supported by Jegadeesh and Titman who found that stocks that perform the best over a three- to 12-month period tend to continue to perform well over the subsequent three to 12 months and stocks that perform the worst will continue to do so over the same period. Therefore, a superior payoff from poor performing stocks depends heavily on an investors capacity to hold those stocks for long periods of time. Looking beyond relative financial ratios The traditional method developed by Graham and Dodd in selecting value stocks using the valuation multiples (such as P/E and B/M) does not necessarily lead to superior returns at all times. Numerous studies have found that value investing does perform well across most equity markets but it is also true that over most reasonable time horizons, the majority of value stocks underperform the market (Piotroski [2000]). Piotroski determines that while a high book-to-market investment strategy, on average, yields positive abnormal returns, the positive returns are generated by only 44% of the sample firms. The reason for this is that the poor valuation ratios for many firms are reflective of poor fundamentals that are only worsening. The typical valuation multiples does not give any indication whether those stocks performance will change or continue to underperform. A portfolio of value firms outperforms both the overall market and portfolios comprised of low B-to-M glamour firms because a small number of high book to market firms are strong enough to raise the portfolios mean performance, compensating for the many high book to market firms that under-perform the market. Damodaran highlights that there is a problem with simply picking stocks based on a single ratio even though these studies indicate that a high book to market value has the potential to earn excess return compared to the market and firms with low book to market ratio. A low price to book ratio may signify that the firm may have financial problems, thus, investors have to evaluate whether the additional returns provided by the firm justifies additional risk. Moreover, a low book value may be justified provided that that firm is expected to continue to earn low returns on equity. Damodaran emphasizes that the price to book value ratio can be written as: Price/Book = (Return on Equity Expected Growth Rate) (Return on Equity Cost of Equity) Stocks with low returns on equity should trade a l ow price to book value ratios. In fact, a firm that is expected to earn a return on equity that is less than its cost of equity in the long term should trade at a discount on book value. In summary, then, as an investor you would want stocks with low price to book ratios that also had reasonable (if not high) returns on equity and limited exposure to risk. Damodaran signifies that a stock with a low price to book value should only be considered undervalued if the stock has a low default risk and a high return on equity. There are also problems with simply using earnings multiple. Damodaran argues that a portfolio of low PE securities will include stocks whose future operating earnings are uncertain. For example, accounting earning are susceptible to manipulation. In addition, one needs to examine whether the earnings are recurring or simply due to onetime items such as gains from divestitures. Damodaran highlights a second point that low PE ratio stocks tend to have large dividen ds yield, which creates a tax burden for investors. Furthermore, a low PE ratio stock may reflect low or negative expectations of future growth in earnings. Several low PE ratio firms tend be in the mature phase in the business cycle where the potential for growth is minimal. An alternative to simply using a PE ratio is to use price to adjusted earnings in order to identify a firms true operating earnings over the longer term rather than one time special items or events that increase the firms earnings. Furthermore, investors may also want to examine the growth rate of firms to ensure that the firm does not at least show a negative growth rate. The problem associated with simply using price to sales ratio is that the low price may justified given the level of risk. Price to sales ratio is determined by dividing the market value of equity by the revenue of the firm. One of the problem with simply determining a value stock as a stock with a low P/S ratio is that a highly leverages firm will trade at a lower multiple of revenues, thus, you may be investing in a risky asset. Furthermore, firms that operate in businesses with little pricing power and poor profit margins will trade at low multiples of revenues. One can argue that value is not ultimately determined by your capacity to generate revenue, rather it is your capability to claim earnings from that revenue. Damodaran underlines that one of the possible alternative is to use enterprise value instead of market value of equity, which will remove the bias towards highly levered firms. The other option is to screen stocks using both price-sales ratio and profit margin. Piotroski (2000) found that applying simple financial stamen analysis techniques to a high book to market portfolio could differentiate strong firms from weak firms. Piotroski explained that this method allowed investors to form a value portfolio that consists of only the firms with the strongest performance prospects, which should outperfor m a generic high book to market portfolio. Piotroski reported that the average return earned by a high book to market investor can be increased by at least 7.5% annually and he found that his investment strategy generated a 23 percent annual return across a 20-year time period (1977-1996). Piotroski highlights that the success of the strategy of based on the ability to predict the future performance of respective firms and the markets inability to recognize these predictable patterns. As we underlined earlier, investors react too pessimistically to poor historical performance, causing the market to temporarily to misprice the firm. Moreover, research analysts and investors tend to neglect these firms and follow glamour firms. One can predict the future performances of these firms by evaluating economic fundamentals such as leverage, profitability and growth. Greenwald, Kahn, Sonkin, and Bienna in their book Value Investing: From Graham to Buffet and beyond, does not follow the traditional method that people use to study value stocks based on low P/E ratios. Rather they use more of a modern value investing approach where the authors preach the wisdom of asset values and margin of safety. A contemporary value investor needs to recognize the franchise value of a firm and the nature of its competitive advantages. The structure of the book consists of valuing a company by first looking at reproduction costs of assets, then earnings power, and finally the value of profitable growth. The authors begin with adjusting the balance sheet of a firm by calculating the cost of assets for a new business entrant. This is followed by valuing a company based on the earnings, assuming no growth. This is accomplished via calculating the earnings power vale (EPV) which looks at the entire company structure- debt, equity, and cash. The difference between the asset value and the EPV (the franchise value) is the value created by the company that has competitive advantage. Fi nally, the value of growth is considered. This book signifies that value investors are skeptical about growth because it is normally not worth anything. They argue that unless the return on capital (ROC) is not greater than the cost of capital (WACC), growth does not create value.