. The Lakonishok Screening Model
Value investing consists of buying unappreciated or ignored stocks at attractive prices. Value investors seek stocks that are priced attractively relative to some measure of intrinsic worth—for instance, they look for stocks selling at temporarily low multiples of price relative to book value, cash flow, earnings or sales. The idea is that, while these stocks may be beaten down, eventually the market will realize the worth in these firms and prices will rise.
Historically, value investing has outperformed the more glamorous growth investment approach, but the approach can also fall out of favor at times. Perhaps more telling, the value approach has also outperformed the market as a whole over the long haul.
The tenets of value investing are found in Benjamin Graham and David Dodd’s book Security Analysis , first published in 1934. In 1949, Graham published another book, The Intelligent Investor , in which he honed his value message for the individual investor. Graham advocated in-depth company and industry analysis in an attempt to uncover sound, growing businesses selling for 50 cents on the dollar.
Over the years, the value torch has been successfully carried by others. In the book Investment Titans (McGraw-Hill, 2001), Jonathan Burton talks with another value investor who made a name for himself, first in the realm of academia and then in the investment management arena—Josef Lakonishok.
This professor turned money manager is one of the founding principals at LSV Asset Management, which manages approximately $112 billion in assets under management. Other firm-founding principals include fellow academicians Andrei Shleifer and Robert Vishny. The firm’s philosophy is to buy out-of-favor companies that are beginning to show signs of awakening. Patience Is a Virtue
Value investing avoids the current stock market darlings. While others are possibly making quick profits—or at least expecting to—value investors may have to face weeks, months or even years of lackluster performance until the market begins to take notice of the attractiveness of a given company or industry. Of course, value investors need to be aware of the risk that the situation may never turn around and, in the worst case, the company fails. For this reason, Lakonishok believes that patience is the most important tool of value investing. You have to be prepared to go against the flow. If you are looking for that “quick hit,” then value investing is not for you.
Furthermore, before you invest in any “value” company, it is important to research the company to gain insight into why the market is discounting it. Investor Behavior
Lakonishok created a stir in the finance community through his research in the field of behavioral finance. He questioned the notion of a completely efficient market and believes that there are inefficiencies investors can exploit in order to outperform the overall market.
He believes that these inefficiencies are based on investor behavior—people place too much emphasis on past performance when attempting to estimate future performance. In his opinion, people are too optimistic in their expectations for growth stocks and too pessimistic in their outlook for value stocks.
Value outperforms growth, according to Lakonishok, because investors don’t expect much from it. When a value stock does better than expected, investors are pleasantly surprised and more apt to reward the company by bidding up the stock.
In contrast, investors tend to expect too much from growth stocks. Yet it is unrealistic to believe that any company can sustain strong growth forever. Eventually, the company will miss an earnings target or announce an earnings warning and, as recent history has shown, the market will not be merciful in its reaction. Value Measures
To locate potential value firms, Lakonishok uses the most common measures of value— price-to-book-value ratio , price-to-cash-flow ratio , price-earnings ratio and price-to-sales ratio .
Price-to-Book Ratio
The book value of a company measures the net worth of the firm’s assets—net shareholder’s equity—and is equal to total assets less liabilities. Value investors such as Graham sought the rare companies with a book value greater than the share price. In such cases, the breakup value of the firm was greater than the share price.
Price-to-Cash-Flow Ratio
A company’s sales and earnings are useful measures of performance, but in order for a company to survive, it must have the cash to finance its activities. Companies that generate sufficient cash can expand during periods of economic expansion as well as cover expenses when sales decline during slowdowns.
Cash flow is calculated by taking net income and adding back depreciation and other noncash charges, such as amortization. The price-to-cash-flow […]
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