The Case for Value Investing

While factor performance often shifts with market conditions, value investing has historically shown resilience across different cycles, making it a compelling all-weather strategy for disciplined, long-term investors.

Certain factor-based investing styles will be in vogue depending on market conditions, but the case for value investing is that it can work in most, if not all, conditions.

So what are the prime features of value investing that make it an attractive factor-based solution?

During growth-fueled markets, stocks can succumb to heavy hype. As such, this can lead to stock market valuations that don’t truly reflect what the company is worth. This can lead to overvalued companies with lofty stock prices driven by speculative buying from unwary investors.

In time, markets may ultimately catch on and the company’s true stock price will be revealed. This could lead to investors being caught off guard, resulting in sell-offs that could leave portfolios reeling. To prevent this, value investing cuts through the hype and focuses on intrinsic value.

Given all this, how does a value investor calculate intrinsic value? Ultimately, it comes down to fundamentals.

Today, investors have a plethora of information available to them to help make sound investment decisions. The prime benefit of factor investing is that it never loses sight of the fundamentals. Is the business performing well? Will its current operations sustain its revenue generation in the coming years?

In order to gauge its fundamentals, value investors have certain financial metrics available to them. The most popular are the price-to-earnings ratio or price-to-book ratio as well as the company’s free cash flow.

Price-to-earnings (P/E) ratio is simply the price of the stock divided by its earnings per share (EPS). The ratio must substantiate the stock’s price relative to the earnings that it is producing, but another popular derivation of the P/E ratio that value investors use is the price-to-book ratio. It measures the company’s stock price relative to the book value, which is all the assets in the company minus its liabilities. That number is divided by the number of shares to get a book value per share metric. Value investors use the price-to-book ratio to determine if the company’s stock is undervalued.

Free cash flow is another vital metric in value investing. It measures the money left after subtracting expenses from operating cash flow. FCF is an important metric because it means that a company has the excess funds to perform activities that can help create shareholder value. This includes reinvesting the cash back into the company to enhance its current operations, offer dividends to its shareholders, or buy back its stock to decrease the number of shares in the market (and thus, bring up the stock price).

When taking these metrics into account, a value investor can then develop a proposed valuation of the company. They compare their valuation with its current valuation to determine if the stock is underpriced, and ensure that a “margin of safety” is available. This margin of safety leaves room for error in valuation, which is bound to happen because nobody can be 100% accurate all the time.

Investors who like the idea of value investing don’t have to deploy the aforementioned financial wizardry to locate undervalued companies themselves. Nowadays, passive exchange-traded funds (ETFs) and the indexes that they follow can provide easy access into the world of value investing without owning a financial calculator. The index with the value investing skew essentially does all the stock selection for them.

For example, CI Global Asset Management offers the CI U.S. Enhanced Value Index ETF, which tracks the VettaFi US Enhanced Value Index index and gives Canadian investors simple, cost-effective exposure to U.S. companies trading below their intrinsic value – all for a competitive 0.30% management fee.

Using a disciplined, rules-based approach, CVLU screens 1,000 large- and mid-cap stocks, distills them to 100 based on value characteristics, and weights them by an assigned value score – eliminating the need for investors to do the research themselves.

In today’s large cap growth-fueled market, Magnificent Seven names have been the dominant theme. As such, some market pundits have dismissed value investing as passe, but others say that it’s poised to make a comeback. Yet the most ardent supporters of value investing will say that its principles were never out of favor.

Value investing doesn’t chase trends or focus on speculative buying hype, celebrity endorsements, or other external factors that could artificially affect a stock’s price. It simply looks at a company from the top-down, and determines if its fundamentals align with its stock price. This can serve an investor well regardless of what factor happens to be the current flavor of the month.

Disclaimer:

Commissions, trailing commissions, management fees and expenses all may be associated with an investment in mutual funds and exchange-traded funds (ETFs). Please read the prospectus before investing. Important information about mutual funds and ETFs is contained in their respective prospectus. Mutual funds and ETFs are not guaranteed; their values change frequently, and past performance may not be repeated. You will usually pay brokerage fees to your dealer if you purchase or sell units of an ETF on recognized Canadian exchanges. If the units are purchased or sold on these Canadian exchanges, investors may pay more than the current net asset value when buying units of the ETF and may receive less than the current net asset value when selling them.

Certain statements contained in this communication are based in whole or in part on information provided by third parties and CI Global Asset Management has taken reasonable steps to ensure their accuracy. Market conditions may change which may impact the information contained in this document.

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