It seems to me counterintuitive that book value should be useful as a value metric. Book value, after all, is a historical accounting measure of a company’s balance sheet. It has nothing to do with “intrinsic value,” which is the measure conceived by John Burr Williams in his 1938 treatise The Theory of Investment Value. Warren Buffett is a well-known proponent of “intrinsic value.” In his 1992 letter to shareholders he provided the following explication of the concept:
In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.” Furthermore, the quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity “coupons.”
The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.
Buffett’s explanation draws a sharp distinction between intrinsic value and book value – “The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business…carries a high price or low in relation to its…book value.” While Buffett’s statement may be true, that does not mean that book value is useless as a value metric. Far from it. As the various studies we have discussed recently demonstrate – Roger Ibbotson’s Decile Portfolios of the New York Stock Exchange, 1967 – 1984 (1986), Werner F.M. DeBondt and Richard H. Thaler’s Further Evidence on Investor Overreaction and Stock Market Seasonality (1987), Josef Lakonishok, Andrei Shleifer, and Robert Vishny Contrarian Investment, Extrapolation and Risk (1994) and The Brandes Institute’s Value vs Glamour: A Global Phenomenon (2008) – low price-to-book value stocks outperform higher priced stocks and the market in general. Why might that be so?
In Contrarian Investment, Extrapolation and Risk, Lakonishok, Shleifer, and Vishny frame their findings in the context of contrarianism, what I like to call the Ricky Roma style of investing:
I subscribe to the law of contrary public opinion. If everyone thinks one thing, then I say, “Bet the other way.”
The problem, as I see it, with low price-to-book investment is that the strategy always flashes a buy signal. When the market is getting very toppy, you can still find the cheapest decile, quintile, quartile, or whatever on a price-to-book basis to buy. That decile might not recede as much as the market in general, but I’d bet odds on that it will still recede. That might not be a problem if, in the aggregate, the price-to-book strategy is able to generate satisfactory long-term returns. A better strategy, however, would remove the opportunities to trade as the market gets expensive, forcing you to sit in cash. I believe this is why Piotroski’s F_SCORE and Graham’s Net Current Asset Value strategies perform so well. When the market gets expensive, those opportunities disappear.
The American Association of Individual Investors website offers various value and growth screens to its membership. Piotroski’s F_SCORE is one such screen. The AAII reports that, of the 56 screens it offers, the only screen that had positive results in 2008 was Piotroski’s F_SCORE (via Forbes):
Believe it or not, the five stocks that AAII bought using Piotroski’s strategy in 2008 gained 32.6% on average through the end of the year. The median performance for all of the AAII strategies last year? -41.7%.
It’s clearly an austere screening criteria if it only lets a handful of stocks get through when the market is high, and in this respect very similar to Graham’s Net Current Asset Value strategy. Right now it has one stock on its screen. That stock? Tune in next week for the full analysis. (I’m starting to sound like The Motley Fool).
Greenbackd 