Value Investing: Bridging Theory and Practice

Value investing refers to the buying or selling of stocks on the basis of a perceived gap between their current market price and their fundamental value – commonly defined as the present value of the expected future payoffs to shareholders. This style of investing is predicated upon two observations about publicly listed companies and their stock prices: (1) a share of stock is merely a fractional claim on the futures cash flows of an operating business, and that claim is the basis of its long-run value; (2) over shorter horizons, prices can deviate substantially from the long-run value of the stock. Value investors buy stocks that appear to be cheap relative to their intrinsic value and sell (even sell short) stocks that seem expensive. One of the most remarkable regularities in the empirical asset pricing literature has been the fact that value investing is consistently associated with positive abnormal returns. Both empirical academic studies and the evidence from a host of professional asset managers seem to confirm this. Over many studies, we see time and again that firms trading at lower pricing multiples, with stronger balance sheets, more sustainable cash flows, higher profitability, lower volatility, lower Beta, and lower distress risk actually earn higher, not lower, future stock returns. This pattern in cross-sectional returns, which I refer to collectively as the “value effect”, was first recognised by famed Columbia University professor Benjamin Graham and documented as early as 1934. Various elements of this effect have been confirmed (and rediscovered) by a host of academic studies in the ensuing 80 years. In this article, I revisit the theoretical underpinnings of the value effect and summarise what is now an extensive body of evidence in support of its existence. I review some basic insights gleaned from accounting-based valuation theory and use these