Investors love value. Whether its groceries or stocks, buying at a discount is good common sense. But what does value actually mean, and how do we find it?
Value investing was first documented in 1934 after unprecedented losses on Wall Street. Using early quantitative analysis, two professors at Columbia Business School, Benjamin Graham and David Dodd, laid the intellectual foundation for what became value. After analyzing hundreds or financial statements from public companies, they found that a stock trading at a discount to its intrinsic value often outperformed a stock trading at a premium to its intrinsic value. In short, cheap stocks outperformed expensive stocks. It’s hard to imagine this was once a revolutionary idea, but the advent of standardized financial reporting during the Great Depression made calculating intrinsic value a new possibility.
There are many ways to find value stocks, but one method outperforms them all. In 2012, Wesley Gray and Jack Vogel of Drexel University found that a strategy that buys companies with a high EBITDA/TEV ratio earned 17.66% per year since 1971. The EBIDTA/TEV ratio compares a company’s operating earnings to its total value. DIY investors can calculate the ratio by dividing EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) by Total Enterprise Value (Market capitalization + Debt + Preferred Stock – Cash & Equivalents). Safe to say, if you’re looking for value, high EBITDA/TEV is the most consistent way to find it, and generates the best results.
Many investors mistakenly believe that a value stock must have dropped in price, traded at a low, or otherwise fallen out of favour. Buying such distressed companies can be a dangerous way of looking for value because it assumes the distress will be short-lived and that earning will eventually recover. Sometimes these types of companies don’t make it back, which is where the term “value trap” comes from. Instead, a safer way to benefit from value is to find a stock that is growing earnings, has a positive price trend, and still has a high EBITDA/TEV ratio. This often eliminates distress situations and helps concentrate, as we do in the Growth Portfolio, on healthier companies.
Like other market anomalies, value is not a silver bullet and can still experience periods of underperformance. But when consistently applied over the long term with good risk management, investors can rest assured value increases the probability of success.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.