In the 1934 classic "Security Analysis" Benjamin Graham (the father of value investing and Buffets' mentor) and David Dodd argued that out-of-favour stocks are mostly under-priced in the market, and that investors could capitalise on this phenomenon to reap strong returns. Conversely, prices for widely popular stocks often are propped by unrealistic expectations and thus vulnerable if these prove too enthusiastic. This philosophy formed the beginnings of what is now widely known as value investing. Although Graham didn't have access to years of data and computers to crunch the numbers, his instincts were spot on and being proven today. Graham used to buy stocks with low Price/Book ratios and hang onto them until they reached booked value.
Lakonsishok, Shleifer & Vishny
The most common metrics to measure value stocks are Price/Book, Price/Earnings, Price/Sales and Price/Cashflow. In 1994, academics Josef Lakonishok, Andrei Shleifer, and Robert Vishny (LSV) published “Contrarian Investment, Extrapolation, and Risk”, a seminal entry in the value investing research field. Using data from 1968 to 1989 they grouped U.S. stocks into decile (10%) segments ranked on price-to-book,price-to-cash flow, and price-to-earnings ratios. The research created 22 sets of deciles, and tracked 5 years of decile-by-decile performance for each price-to-x criteria. They concluded that value deciles based on low price-to-x values consistently outperformed "glamour" deciles with high price-to-x values, by wide margins, as shown below with the Price-to-book example:
Fama & French
Eugene Fama of the University of Chicago’s Graduate School of Business and Kenneth French from MIT’s Sloan School of Management tackled a similar question in 1998’s “Value versus Growth: The International Evidence.” The researchers found that, from 1975 to 1995, value stocks outperformed glamour stocks in 12 of 13 major national equity markets. In their opinion, this laid to rest the possibility that the value out-performance noted by LSV was sample-specific happen-stance. “Rather than being unusual,” Fama and French concluded, “the higher average returns on value stocks in the United States are a local manifestation of a global phenomenon.”
In his 1996 best-seller, "What Works on Wall Street: A Guide to the Best-performing Investment Strategies of All Time", James P O'Shaughnessy tested risk-adjusted returns for mechanical portfolio creation strategies based on Price/Book, Price/Earnings, Price/Sales, Price/Cashflow and various other fundamentals, over a 52 year period on the US markets. This is our favourite book and we consider it a seminal work. He also convincingly concluded that small-cap outperformed large cap, low price-to-x outperformed high-price-to-x and Price/Book and Price/Sales were the strongest performing indicators.
The Brandes Institute
In October 2008, in another seminal research piece, the Brandes Institute sought to extend the research of Lakonishok, Shleifer and Vishny by first validating their methodology and then by adding 14 decile sets for the period 1990 to 2003 for a total of 36 decile sets. The research confirmed that the theory still held strong in more recent times.
The Brandes researchers then sought to build upon Fama and French’s 1998 work, examining value stocks and glamour stocks from a global perspective. Using the same methodology applied in the United States, they studied equities traded in 23 developed markets to evaluate global results. The results were startling and very similar for small and large cap stocks and are shown below:
The PowerStocks Research tests
Unfortunately, the JSE was not included in any of the above research so naturally we decided to publish a seminal piece of research work ourselves, by conducting similar exersises locally. This research is currently work in progress, as mountains of data have to be analysed, but we have published our findings so far for Price/Book (5 sets of 5 year periods, 7 sets of 3 year periods and 8 sets of 1 year periods), Price/Earnings (same sets as Price/Book) and Piotroski (one extensive 14 year period) to give you the comfort that the research is being mirrored and even experiencing a multiplier effect on the JSE. We have also completed trough-to-peak JSE backtests to the last big 2003 crash to see how effective these strategies are at picking winners from market bottoms.
You can find this research in the STRATEGIES menus. Each stock picking strategy we follow will have a "BackTests" menu item that will become active once we release findings.