In its purest form, value investing involves solely buying cheap companies. Just cheap companies. Studies of valuation either use high minus low (buying the cheapest stocks and shorting the most expensive stocks) or separate stocks into deciles (10 evenly split groups) or quintiles (five evenly split groups) based on their relative valuation ratios. No consideration is given for any other characteristics.
The big challenge with a pure value strategy (or a pure momentum, a pure growth strategy, etc.) is the actual stocks designated for purchase. In the case of value, an investor will end up looking at a list of stocks so unattractive that they are unlikely to even be allowed to entry into the building where a beauty contest is being held. There will be more than enough stocks with big enough flaws and risks to cause an investor to openly question the rationality of following the strategy.
A way around this problem is to require stocks to have additional characteristics. In “Fact, Fiction and Value Investing,” Clifford Asness et al. explained how including momentum and profitability components in a value strategy increased risk-adjusted returns. Strong momentum occurs when a stock’s return is above average over a period of time (e.g., 26 weeks). Profitability, as the word implies, means a company is making money.
Taking a step back to look at the bigger picture reveals why this would be the case. Value occurs when perceptions about the company drive down the price investors are willing to pay relative to a fundamental metric (book value, earnings, cash flow, etc.) Momentum occurs when investors buy or hold onto to a stock because its price is rising. Profitability implies the company is making money, and investors mostly prefer companies that are expected to make money over those that aren’t. (There are always some speculative exceptions to this from time to time.) Combining momentum and profitability (or a broader measure of quality) results in both finding stocks recognized as bargains by other investors and reducing the odds of buying stocks that are cheap for a reason. The diversification benefits of momentum and profitability relative to value are the icing on top of the cake—and tasty icing at that.
Here at AAII, our value-oriented portfolios are not pure value. The Model Shadow Stock Portfolio uses profitability as a criterion for adding and selling a stock. The portfolio also requires stocks to have a relative price strength rank (the measure of momentum) within the top half of all stocks in order to be considered as buy candidates. The AAII Dividend Investing portfolio requires underlying financial strength and dividend growth in addition to an attractive valuation. Even the value strategies used within our Stock Superstars Report portfolio include quality components.
It’s not just us. The renowned value investor Warren Buffett evolved from Benjamin Graham’s “cigar-butt” strategy to considering quality as well. (The term “cigar butt” refers to picking up discarded cigars with one puff left, meaning companies with some semblance of intrinsic value left in them.) Joel Greenblatt’s Magic Formula requires companies to earn a minimum return on their capital. These men are far from being alone.
Investing in cheaply valued stocks works really well over the long term. (Over short periods of time, any style of investing can and will flop.) The challenge comes from purely investing in value with no consideration for any other factors. Though pure value works mathematically when a large enough number of stocks is purchased, the strategy requires a strong tolerance for owning very risky companies. Incorporating additional traits will make the stocks you identify more palatable with potentially even higher returns.