Macro & Microfundamentalist Value Investing: Does It Work?
Value investing, as defined by Benjamin Graham, is a strategy of buying securities only when their market prices are significantly below the calculated intrinsic value. It entails buying what is safe and cheap with little or no concentration on forecasts of relatively near-term flows. Safety is measure by strong financial position, by the quality of the resources. The gap between the value and the price is referred to as the “margin of safety.”
The process consists of:
- Selecting securities for valuation
- Estimating their fundamental values
- Calculating the appropriate margin of safety required for each security (Graham suggested that the gap be about one-half and not less than one-third, of the fundamental value)
- Calculating how much of each security to buy
- Deciding when to sell securities
Fundamental investors pursue one of two approaches:
- Macrofundamentalists focus on broad factors that affect securities such as inflation rates, interest rates, exchange rates, unemployment rates, and rates of economic growth on a national or international level. This approach is referred to as “top down,” starting from the overall economy then working down to the individual companies and securities.
- Microfundamentalists study the history of a particular security, noting how the price has changed in response to various economic factors such as earnings, industry conditions, new product introductions, improvements in production technology, management, growth in demand, change in demand and financial leverage, new plant and equipment investments, acquisition of new companies, etc.
If either of these investors find that their estimates of future earnings or other important variables exceed expectations, they would make a purchase.
Historical records confirm that over extended periods of time, value investing strategies has returned better results than the market or alternate methods in almost all periods and market types.
How are stocks valued?
Market value per share (current stock price), is vastly different than the company’s real intrinsic capital value, known as book value per share. Stock price represents price agreed on by buyers and sellers at that particular moment (highest that a buyer will pay, lowest that a seller will accept). Book value per share is the capital value of the company; total net worth minus intangible assets (such as goodwill), divided by the number of outstanding common stock. Stock price should always be compared to book value per share. A close relationship could be a good opportunity.
Price-to-earnings (P/E) ratio is one of the most popular and important tests used by investors. It shows how the market views a particular stock based on earnings.
You can conduct the following test to determine whether a value portfolio produced better than average returns:
- Take the stocks and sort them into groups using a measure of value such as market price to book price or market price to earnings. The value stocks would have low price to book or price to earnings ratios.
- Record the price at the start—usually first day of trading of the year.
- Record the price at the end of the year.
- Add the dividends paid to change in price to get the total return on each portfolio for that one-year period.
- Compare the total return of each portfolio.