SMART MONEY March 26, 2014 8:23 am

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Be brave, and patient, to make a fortune in value investing
By John Authers Author alerts
Combining two popular approaches will reward stockpickers
ortune favours the brave. And everything comes to he who waits. In these two well-worn phrases lie differing justifications for two
different approaches to value investing. Both have merit, but the trick is to combine them.
Value investing has been popular ever since it was promulgated by US academic Benjamin Graham in the 1930s. His idea was that
many companies had grown so cheap in the wake of the Great Crash and the subsequent economic depression that it was possible to
buy them for less than their intrinsic value.
It received a separate and very different impetus in the 1970s, when a vast research project by two more academics, Eugene Fama and
Kenneth French, showed that over time, cheap stocks which they measured by price-to-book ratio did indeed outperform. They
labelled this the value effect.
These approaches are different. But there is also an academic debate over how to explain the Fama and French findings which leads, in
turn, to two different kinds of value investing. Mr Fama himself, who was made a Nobel economics laureate last year, explains the
value premium in terms of risk. Cheap stocks are generally cheap because they are in bad shape and face big risks. Therefore a value
effect over time is just what would be expected in an efficient market higher risk is related to higher long-term returns.
A second explanation comes from behavioural finance, and suggests that markets are inefficient. As humans we get excited about
stocks with a great story to tell, and tend to ignore the more humdrum boring stocks that plug away producing predictable profits and
dividends. Buying such stocks is a way of taking advantage of inefficiency and in the long run it will pay off. Both approaches are about
value, but they are different.
Brave and patient approach
The effort is now on to systematise both strategies. Socit Gnrales Andrew Lapthorne labels the approaches brave and patient
value, and has a strategy for each. The patient approach involves buying stocks with strong balance sheets and regular dividend yields.
This strategy is also called quality income and will work well in the long run. The disadvantage is that stolid dividend-payers tend to
underperform in a strong bull market, as we have had for five years.
The brave approach involves buying the 200 cheapest stocks, relative to their own sectors, in the developed world. This compensates
for the fact that some sectors will naturally look cheaper on basic metrics than others, and uses a weighted combination of five value
measures price/earnings, forward price/earnings and price/book multiples as well as, for non-financial companies only, free cash flow
to price, and earnings before interest, tax, depreciation and amortisation to enterprise value. These companies are reshuffled every
quarter, so the index will not ride for long with its winners whose share price takes off. It is now available as the SG Value Beta index.
Tying to it might make it a little easier psychologically to do the things that deep value investors need to do, such as buy shares in BP
while its oil was still pumping into the Gulf of Mexico.
As Mr Lapthorne points out, the two strategies prove to be remarkably complementary. The brave value index has a high beta,
meaning that its fate is linked to the market. It outperforms in good times, and will suffer far greater falls in a downturn. Its ultimate
gains come from a rising share price. Meanwhile, patient value is less correlated to the market, and delivers its returns by
compounding dividends in the long term.
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Over the last 20 years, patient value returned 11.9 per cent per year, while brave value gained 14.3 per cent per year, with far higher
volatility. In combination they returned 13.4 per cent per year, with lower volatility than that achieved by an equal-weighted market
index, which returned a compound 8.4 per cent per year. Wherever the returns from value come from, they mount up in the long run.
Shortage of value stocks
This is far removed from the original Graham approach of buying stocks so cheap that they virtually pay for themselves. But
sometimes there are few such stocks. By Mr Lapthornes own screen, using Graham criteria, barely more than 20 stocks in the MSCI
World index now qualify. These do include intriguing names like Intel, BHP Billiton and Vodafone, along with a raft of large Japanese
groups, and there is always the option of staying in cash if stocks look too expensive but it does suggest limitations to the original
Graham approach.
And maybe the later Graham would approve. In the 1950s, in retirement, he said he was no longer an advocate of elaborate
techniques of security analysis to find superior value opportunities. He proposed a screen based only on historic p/e, the AAA-rated
corporate bond yield, and a test of balance sheet strength.
This, he said, seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of
work. That could be a good description for the value screens of today.