IN THIS CHAPTER

Evaluating value investing

Weighing value against growth for performance and risk

Recognizing ETFs that fit the value bill

Knowing how much to allocate

Choosing the best options for your portfolio

Why do American suburbanites gingerly cultivate their daisies, yet go nuts swinging spades or spraying poison chemicals at their dandelions? Why is a second cup of coffee in a diner free, but a second cup of tea isn’t? Some things in this world just don’t make a lot of sense. Why, for example, would slower-growing companies (the dandelions of the corporate world) historically reward investors better than faster-growing (daisy) companies? Welcome to the shoulder-shrugging world of value investing.

I’m talking about companies you’ve probably heard of, yes, but they aren’t nearly as glamorous as Microsoft or as exciting as Tesla. I’m talking about companies that usually ply their trade in older, slow-growing industries, like insurance, petroleum, and transportation. I’m talking about companies such as UnitedHealth Group, Procter & Gamble, ExxonMobil, and Exelon Corporation (providing electricity and gas to customers in Illinois and Pennsylvania).

I see you yawning! But before you fall asleep, consider this: Since 1927, large-value stocks have enjoyed an annualized growth rate of roughly 12 percent, versus 10 percent for large-growth stocks — with roughly the same standard deviation (volatility). And thanks to ETFs, investing in value has never been easier.

In this chapter, I explain not only the role that large-value stocks play in a portfolio, but also why you may want them to be the largest single asset class in your portfolio. Take a gander at Figures 6-1 and 6-2. They show where large-value stocks fit into the investment style grid (which I introduce in Chapter 4) and the impressive return of large-value stocks over the past nine or so decades.

Pass the dandelion fertilizer, will ya?

Six Ways to Recognize Value

Warren Buffett knows a value stock when he sees one. Do you? Different investment pros and different indexes (upon which ETFs are fashioned) may define “value” differently, but here are some of the most common criteria.

• P/E ratio: As early as 1934, Benjamin Graham and David Dodd (in their book with the blockbuster title, Security Analysis) suggested that investors should pay heavy consideration to the ratio of a stock’s market price (P) to its earnings (E) per share. Sometimes called the multiple, this venerable ratio sheds light on how much the market is willing to cough up for a company’s earning power. The lower the ratio, the more “valuey” the stock. (The P/E ratio as it relates to growth stocks is addressed in the previous chapter.)

• P/B ratio: Graham and Dodd also advised that the ratio of market price to book value (B) should be given at least “a fleeting glance.” Many of today’s investment gurus have awarded the P/B ratio the chief role in defining value versus growth. A ratio well below sea level is what floats a value investor’s boat. Book value refers to the guesstimated value of a corporation’s total assets, both tangible (factories, inventory, and so on) and intangible (goodwill, patents, and so on), minus any liabilities.
• Dividend distributions: You like dividends? Value stocks are the ones that pay them.
• The cover of Forbes: Magazine covers are rarely adorned with photos of the CEOs of value companies. While growth companies receive broad exposure, value companies tend to wallow in obscurity.
• Earnings growth: Growth companies’ earnings tend to impress, whereas you can expect value companies to have less than awe-inspiring earnings growth.
• The industry sector: Growth stocks are typically found in high-flying industries, such as Internet commerce, computers, wireless communications, and biotechnology. Value stocks are more often found in older-than-the-hills sectors, such as energy, banking, transportation, foodstuffs, and toiletries.

Looking for the Best Value Buys

Many academic types have looked at the so-called value premium and have tried to explain it. No one can agree on why value stocks have historically outperformed growth stocks. (A joke I remember from my college days: Put any three economists in a room, and you’ll get at least five opinions.)

Some people say there is hidden risk in value investing that warrants greater returns. They explain that although the standard deviation for the two asset classes is about the same, value stocks tend to plummet at the worst economic times. This argument is not all that persuasive. During some serious market downturns, such as 2008 and again in 2020, value was hit harder than growth. But during other market downturns, such as the dot-com disaster of 2000 to 2002, value stocks proved much more buoyant than growth stocks. Others say that value stocks outperform growth stocks because of the greater dividends paid by value companies. Growth companies tend to plow their cash into acquisitions and new product development rather than issuing dividends to those pesky shareholders.

Here’s the best explanation for the value premium, if you ask this humble author: Value stocks simply tend to be ignored by the market — or have been in the past — and therefore come relatively cheap. When value stocks do receive attention, it’s usually negative. And studies show that investors tend to overreact to bad news. Such overreactions end up being reflected in a discounted price.