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Value Investing and Mr. Market

In an era of hot markets and wild speculation it is useful to consider a well-seasoned and more conservative value approach. To assist in telling the value story, I start with Benjamin Graham's Mr. Market parable which he spun in his book The Intelligent Investor:
"Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly."
Value investing is all about figuring out when Mr. Market is overly enthusiastic or fearful and then taking advantage of the situation. Graham suggested that companies with low Price to Earnings (P/E) and Price to Book (P/B) ratios are likely those that have been priced by a fearful Mr. Market. On the other hand, high P/E and P/B ratios likely indicate an enthusiastic Mr. Market. The P/E ratio can be found in most newspapers and is determined by dividing the company's price per share by its annual earnings per share. The P/B ratio may be unfamiliar to some investors; it can be determined by taking a stock's price per share and dividing it by the value of the company's assets per share. Graham indicated that stocks with P/E ratios of less than 15 and P/B ratios of less than 1.5 are particularly interesting for purchase whereas stocks with higher ratios are more speculative. There are a number of other value indicators such as a high dividend yield which is the basis for various popular "beating the DOW" approaches (

Its all very well to talk about Mr. Market's emotions, but is it really possible to profit from them? Graham cites a study in The Intelligent Investor that looked at the P/E ratios of stocks in the Dow Jones Industrial Average (DOW) between the years of 1937 and 1969 (See Table 1). In this study, the 30 DOW stocks were split into a group of 10 low P/E stocks and 10 high P/E stocks. The low P/E group outperformed the DOW and the high P/E group generally did poorly. David Dreman's fascinating book Contrarian Investment Strategies: The Next Generation picks up where Graham left off. In his book Dreman examines the returns of the largest 1500 U.S. companies from 1970 through to 1996 when sorted by P/E, P/B & dividend yield. To do each comparison he split the 1500 companies into 5 equal groups (called quintiles) with group one composed of stocks with the lowest ratios and group 5 the highest (See Table 2). The combination of these two studies teaches that low P/E stocks, in the U.S. outperform their higher P/E counter parts by a wide margin and have done so over a period of nearly 60 years. Furthermore, over the last quarter century low P/B and high dividend yield stocks have also performed admirably.

Period 10 Low P/E Stocks 10 High P/E Stocks All 30 DJIA Stocks
1937-1942 -2.2 % -10.0 % -6.3 %
1943-1947 17.3 % 8.3 % 14.9 %
1948-1952 16.4 % 4.6 % 9.9 %
1953-1957 20.9 % 10.0 % 13.7 %
1958-1962 10.2 % -3.3 % 3.6 %
1963-1969 8.0 % 4.6 % 4.0 %
Table 1: Average Annual Percentage Movements of the DOW Sorted by P/E (1937-1969).

Quintile Price / Earnings Price / Book Value Dividend Yield
1 (Low) 19.0 % 18.8 % 16.1 %
2 17.4 % 16.3 % 17.5 %
3 14.6 % 14.6 % 15.1 %
4 13.1 % 13.7 % 13.8 %
5 (High) 12.3 % 12.0 % 12.2 %
Average 15.3 % 15.1 % 14.9 %
Table 2: Annual Return of Selected Value Strategies from January 1 1970 to December 31 1996.

To gain some insight into the Canadian experience one can examine some of the findings that Thomas Liston described in The Performance of P/E Ratios in Predicting Canadian Stock Returns (Thesis, Liston looked at stocks in the TSE 300 from 1988 to 1998 and split the stocks up into P/E quintiles with a wrinkle. He defined an extra "quintile" for stocks with negative P/E ratios (which I'll label quintile zero) so that quintile one contains only stocks with low but positive P/E ratios (See Table 3). The group of low but positive P/E stocks outperformed the market 82.5% of the time by an average of more than 5% annually. It is heartening to know that low P/E stocks outperform both above and below the 49th parallel. It is likely that the international nature of value extends to low P/B and high dividend yield stocks as well.

P/E Quintile: 0 1 (Low) 2 3 4 5 (High) TSE 300
Annual Return 7.33% 7.47% 4.98% 4.30% 4.18% 4.45% 2.22%
Out Performance 70.0% 82.5% 77.5% 77.5% 70.0% 67.5%
Table 3: Annual Returns vs P/E quintile for the TSE 300 from 1988 to 1998.

Conservative investors know that frequent trading can rapidly rack up commissions and many prefer to minimize these costs. Fortunately for value investors, Dreman has shown that frequent trading is not necessary if you buy low P/E stocks (See Table 4). It is apparent from this data that rebalancing a value portfolio once every few years is more than sufficient. As a result, the value approach seems ideally suited to the long term DRIP (Dividend ReInvestment Plan) & SPP (Share Purchase Plan) investor.

Hold Period
P/E Quintile 2 Years 3 Years 5 Years 8 Years
1 (Low) 18.7 % 18.1 % 18.7 % 18.4 %
2 16.9 % 16.5 % 17.1 % 17.5 %
3 15.3 % 15.2 % 15.5 % 16.2 %
4 13.5 % 13.7 % 14.4 % 15.3 %
5 (High) 11.9 % 11.3 % 11.8 % 12.8 %
Average 15.3 % 15.0 % 15.6 % 16.2 %
Table 4: P/E Buy-and-Hold Annual Returns from January 1 1970 to December 31 1996.

Value strategies offer a record of superior performance and allow for a low intensity approach to investing that saves on commissions. Furthermore, by buying stocks with low P/E or P/B ratios the investor enjoys a margin of safety since the earnings and assets of a going concern with such ratios has an intrinsic value that provides support for the stock price. As with all investment techniques, the future performance of value investing is unknowable. However, for the conservative investor, value investing is one of the best options for dealing with Mr. Market.

First published in May 1999.

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