Taking Advantage of Value Stocks

A few posts back, we discussed how researchers Eugene Fama and Kenneth French found that small cap stocks over long periods provide higher returns to an investor than both the overall market average or the large cap stocks, such as the S&P 500 or the TSX 60. The famous "Three-Factor" paper in which they published these results also revealed that Value stocks present attractive properties for an investor.

What is a Value stock?
Any stock whose market price is low compared to some fundamental accounting measure such as book value, earnings, dividends, sales or cash flow is a Value stock. Value stocks are distinguished from their opposite, Growth stocks. The simplest classification, and the one used by Fama and French to describe the Value effect, is based on Price to Book Value. As with small companies, different index providers use different measures or combinations thereof to put stocks into the Value or Growth category. MoneyChimp's Index Styles page tells how the main index providers like Morningstar, Russell, MSCI Barra and Standard and Poors identify the Value stocks (see CanadianFinancialDIY's comparison and opinion on which Value index is best).

Why would Value Stocks interest an investor? Whichever index is used, the same benefits described below, more or less, are observed. It is worthwhile to note that the Value stock benefits also hold in different countries and markets (see William Bernstein's discussion of the Fama French findings and his assessment of actual US and international Value fund performance; another good source is the book All About Asset Allocation by Richard Ferri).

1. Higher returns - Over a long holding period of twenty years or more, Value returns significantly outpace - by 1% up to 4 or 5% annually - Growth and the overall market average. The effect is more pronounced among small companies than large ones. Another MoneyChimp page called Building Portfolios has a couple of simple calculators where a click will show the past performance results of Value vs Growth for large and small caps in the USA. It is essential to note that Value out-performance reliably occurs over long periods. Sometimes Growth stocks go on a run for multiple years beating out Value.
2. Non-correlation with the overall market - Value stocks do not move in tandem (i.e. are not correlated) with the total stock market average. Putting Value stocks into a portfolio with total market funds and other non-correlated assets like bonds and REITs lowers the volatility /risk of the overall portfolio.

Ways to Invest in Value Stocks

• ETFs for US and International Stocks - A couple of dozen choices can be found in the listing of Value Stock ETFs in Stock-Encyclopedia. For those who wish to combine the Small Cap and Value effect benefit, there are several Small Cap Value ETFs. Amongst the PowerShares International ETFs are a number of RAFI index funds, which use a form of value selection. There are ETFs for Europe (Symbol: PEF), Developed Markets excluding the USA (PXF), Developed Markets ex-USA Small and Mid-Cap (PDN), Emerging Markets (PXH) and even for Japan by itself (PJO).
  
• ETFs in Canada - There are two choices: iShares S&P/TSX Value Index ETF (XCV) and Claymore Canadian Fundamental Index ETF (CRQ).
  
• Mutual Funds - Hundreds of Value funds are available in Canada, covering both Canadian and US companies. To find them, go to GlobeFund's Fund Selector page, then in the box Option C / Name type in Value. It will be necessary to wade through the funds one by one to see exactly what criteria each fund uses - usually it is stated in the fund objectives - to determine value. Such mutual funds will go beyond using only fundamental ratios to pick what they consider to be value stocks and will analyze many aspects of each company to try to get superior returns, though only some succeed as the majority do not.
  
• Individual companies - Use a stock filter such as the Globe Investor Stock Filter (note that discount brokers such as BMO Investorline also typically have such a tool within their website) to select companies. Type in a maximum price/book value or price to earnings per share e.g. 1 for P/B and 12 for P/E and run the search. Click the Financial and Ratios tabs to see the numbers and click on the P/B column heading to sort low to high. The stock filter then also allows you to start narrowing the possible investment targets using other fundamental factors like net profits, sales growth, debt level etc. Listing the holdings of ETFs, which are all publicly available on their websites, is a quick way to find reasonably actively traded Value companies since the ETFs usually exclude companies with too little stock trading.

As their name suggests, Value stocks, in whatever form, can be a valuable addition to an investment portfolio.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.