How to compose a Value Portfolio

Value investing relies on fundamental analysis to determine when a stock is trading at less than its intrinsic value. This style is the opposite of growth investing, where investors are willing to chase after stocks that have good growth records and have already risen in value. Value investors are bargain hunters who are looking for companies that have good ideas or products or that have been performing poorly but have good long-term prospects. A good example of value stocks are the home-building companies that have declined in price because of a bubble in the real estate market. The stocks of these companies are trading at around four times their earnings multiples. If interest rates in the economy rise, fewer new homes will be built and sold. Consequently, home-building companies are attractive investments for value investors who are willing to wait until the home-building cycle moves back into an expansionary mode. When a sector of stocks has lagged other stock sectors over long periods, the gap eventually narrows, and the laggard sectors likely will outperform those other stock sectors in the future. This is known as the regression to the mean. The flip side of the coin is that stocks that have been outperforming the market likely will revert to the mean and underperform the market at some stage in the future. Thus value investors are always looking for stocks that are considered to be trading below their expected long-term growth rates.

A definition of a value stock is one in which the company’s P/E ratio is lower than its earnings growth rate. Chesapeake Energy, for example, is considered a value stock in that its 2007 expected earnings growth rate is 13 percent and its 2007 P/E ratio is 9.6. A stock whose P/E ratio exceeds its growth rate is not considered a value stock.

There is not unanimous agreement on the definition of value stocks. Some definitions center on low P/E multiples or those that are below the market multiples. Others focus on low multiples of cash flow or low price-to-book ratios. The most conservative definition of a value stock is one that has an above-average dividend yield. Outof- favor stocks are also classified by some as value stocks. For example, when Intel, Cisco, and many other growth stocks fell in value in 2006, many value fund managers bought these stocks as value stocks. Depending, then, on how you define value, many investors come up with different sets of value stocks. Some of the bases for determining value stocks are discussed in greater detail below.

Price / Earnings Ratio
The P/E ratio for a stock is calculated by dividing the current market price of the stock by the earnings per share. This can be done using the past four quarters’ earnings, which is known as a trailing P/E ratio. Alternatively, the P/E calculation can use expected earnings based on forecasts for the upcoming year’s earnings. This future P/E ratio may be of greater significance to investors because this is an indication of the expectations for the stock in the future. However, investors should not base their decisions solely on P/E multiples because the type of industry and the capital structure also affect the P/E ratio. Some industries have higher average P/E ratios than others, and it would not necessarily be a meaningful evaluation to compare the P/E ratios across industries. For example, the pharmaceutical companies have much higher multiples than the brokerage stocks. Comparing Schering-Plough Corporation, then, with a trailing P/E ratio of 33, with Goldman Sachs, with a P/E ratio of 11, would be meaningless. Some industries require much greater investments in property, plant, and equipment than others, which means that they are probably much more leveraged in terms of debt. Generally, companies with high debt ratios are much riskier than companies with low debt ratios, and these more highly leveraged companies will have lower P/E ratios.

A low P/E ratio is a relative measure. Some investors might consider Schering-Plough to be a growth stock with a multiple of 33, whereas others would consider this to be a value stock as compared with the high multiples of some of the other stocks on the exchanges.

Price-to-Book Ratio
This measure compares the market price to the book value. The book value per share is computed as assets minus liabilities divided by the number of outstanding shares. Value investors look for stocks with market values that are below their book values. Benjamin Graham, who did the pioneering work on fundamental analysis, has some guidelines for stock pickers, which include buying a company’s stock when the stock price is less than two-thirds the book value per share.

There are a number of reasons why a low price-to-book ratio is not reason enough, by itself, to buy a stock. The book value per share is an accounting measure, and it can be distorted by using different accounting methods within the generally accepted accounting principles (GAAP), such as the use of accelerated depreciation versus straight-line depreciation or last in, first out (LIFO) versus first in, first out (FIFO) for valuing inventory. The discrepancy between the historical cost of the company’s assets and their market value will make the book value per share diverge from the realizable value per share. Thus it is a good idea to use more than one measure of value to select value stocks.

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