Night School: Values-Based vs. Value Investing

We have long practiced values-based investing. This means investing in companies that offer products or services that are socially beneficial, have ethical business practices and a long-term perspective, emphasize diversity in their executive staff and board of directors, treat their employees and communities well, and minimize their negative environmental impact. This is commonly known as socially responsible or sustainable investing.
We also practice value investing, which means focusing on whether a stock is undervalued (underpriced) or overvalued (overpriced).
What Is Undervalued?
At its simplest, a company’s stock is undervalued when its share price on the stock exchange is selling for less than the intrinsic value of the company.
There are a number of ways to determine this. In most sectors of the economy, our favorite measure of valuation is the market value of a stock versus how much cash the company’s business operations generate. When the business generates more cash than is needed for normal business operations, any excess (or “free”) cash flow can be used by the company to pay dividends, expand its operations, reduce debt, invest in its employees, acquire another company, or repurchase its shares.
We also consider a company’s stock price per share relative to its earnings, dividends, book value, and revenues. In each case, we evaluate these versus a company’s own history, as well as against its industry peers.
A stock is expensive or inexpensive not based on the share price, but on its valuation (cash flow, earnings, book value, or revenues) per share. For example, Biogen (BIIB) sells for $280, with earnings per share of $28.00. Cisco (CSCO) sells for $45, with earnings per share of $2.80. Biogen’s price/earnings ratio per share is 10 ($280/$28.00), while Cisco’s is 16 ($45/$2.80). Though Biogen’s stock price is more than six times the price of Cisco, Biogen’s valuation is cheaper than Cisco’s (10x versus 16x). On this single valuation measure, Biogen is less expensive than Cisco.
Though we consider valuation to be the most important factor in determining future stock returns, we also consider other factors, especially the financial strength, profitability, and management skill and integrity of a company.
The essence of value investing is being willing to buy what is inexpensive, which usually means a stock that is unpopular or overlooked.
Conventional Wisdom
It’s easy to go along with the conventional wisdom about an investment. The problem, however, is that the conventional wisdom is often wrong. Human nature tends to foster crowd behavior, and the crowd is usually unduly optimistic or pessimistic about an investment, resulting in mispricing. Assets that are unpopular tend to be underpriced relative to how things turn out, as the pricing reflects low expectations that may turn out to be not so bad. Assets that are widely popular tend to be overpriced and ultimately disappointing because of unrealistically high expectations. Whether a company lags or exceeds expectations is what drives its stock price movement.
Value Versus Growth
The “growth” approach to investing, choosing companies that have grown faster than average and which have seemingly superior prospects, is popular. This is understandable. Who wouldn’t want to invest in companies that are growing fast or have exciting concepts? Unfortunately, these are the types of companies whose prices are bid up too high because of unrealistically high expectations. As a result, this approach of “growth” investing has had significantly inferior long-term returns when compared to value investing. Because of new competition, management stumbles, and other unforeseeable reasons over time, it is common for “growth” companies to fail to meet their high expectations.
Human nature reveals another behavioral flaw in investing that results in the tendency to sell at market bottoms because of bleak conditions or to buy at the top because of rosy conditions. Again, such conditions are already reflected in market prices, and it is change versus expectations that moves markets.
Investment legend Warren Buffett is credited with saying, “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”
A key principle of value investing is that starting price matters. Over decades of market history, buying in at high (expensive) valuations has resulted in well-below-average returns, and buying at low valuations has produced well-above-average returns.
Contrarian Investing
Value investing means going against, or contrary to, the conventional wisdom. This is exceedingly hard to do, especially when market prices go against you in the short term. It requires discipline and patience to wait until the undervaluation (or overvaluation) is recognized by other investors.
Let market opportunities come to you, and take what the market gives you. If prices are inexpensive, pounce – if your analysis shows an attractive value. If the price declines, buy more. If prices are substantially overvalued, sell some or all of the holding and reinvest in undervalued stocks – or hold the proceeds in interest-bearing cash until better opportunities arise. They will, sooner or later. They always have.
The discipline and patience of value investing can make an investor look foolish at first, whether buying before a stock price bottoms or selling before the ultimate top. It’s impossible to hit either one and can feel a bit embarrassing in the short run. However, as Buffett has said, “Holding cash might be uncomfortable, but not as uncomfortable as doing something stupid.” We try very hard not to do something stupid here at Clean Yield.