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Peter Elston: Why value investors don’t have to restrict themselves to cheap stocks

Having completed a series of quarterly blogs on the subject of risk, Seneca's Peter Elston turns his attention to value investing in a new series.

Peter Elston

By Peter Elston, Seneca Investment Managers
Friday December 02, 2016

I’m thinking about launching a smart beta ETF called the “Smart Alpha Smart Beta ETF”. It would invest only in shares that go up. At the end of every month, the fund would be rebalanced into those shares that will go up the following month.

“How do you pick the shares?”, I will no doubt be asked. “I don’t, the ETF will track an index of shares that go up”. “Ah, I see” may be the response, perhaps followed by “Sounds good. Where can I buy?”

There seem to be so many ways of systematically slicing and dicing markets nowadays in an attempt to beat them that I’m sure my idea might get some way before I was rumbled.

The first attempt to set out a framework for picking good-performers was that of Benjamin Graham and David Dodd in the 1930s. They never called it ‘value investing’, though that is what it later came to be known as.

Many investors have since put their own slant on it, to the extent that now it is more a principle than a framework - the principle being that if you buy things that are cheap you have a better chance of beating the market and thus making good money.

The question of course is how you assess the cheapness of a stock.

For Graham and Dodd, it was about calculating the intrinsic value of a company, then buying those whose market capitalisation was well below their intrinsic value. It took their bible, Security Analysis, 700 pages to explain how to do this.

In 1992, Eugene Fama and Kenneth French wrote a seminal paper entitled ‘The Cross Section of Expected Stock Returns’. They found that a stock’s market capitalisation and price-to-book ratio tended to determine its price performance over subsequent periods (smaller and cheaper stocks often did better than larger and pricier ones).

They called these two factors ‘size’ and ‘value’, with the latter quickly coming to be associated with Graham and Dodd’s ‘value investing’. Indeed, index providers such as MSCI and S&P subsequently constructed indices based on ‘size’ and ‘value’ – and others such as volatility, high dividend yield, quality and momentum. According to MSCI, it created ‘seven factor indexes based on these six factors (with two indexes for Low Volatility: the Minimum Volatility index and the Risk Weighted index).’

As with Fama and French, indices based on ‘value’ have also become associated with Graham and Dodd, and it would appear there are now many who think they are the same thing.

They are not.

While stocks identified using Graham and Dodd’s framework or a variant thereof may well have low price-to-book ratios – or low price in relation to the various other metrics that value factor indices also seek to capture such as earnings, sales, earnings, cash earnings, net profit, dividends, and cash flow – there is a lot more to ‘value investing’ than a few simple calculations.

It is the difference between on the one hand a system of analysis that took 700 pages to set out and on the other a few simple calculations that would take a couple of minutes to perform. In other words, the difference is a big one.

Put simply, there are stocks that might look cheap but which in reality are not. A stock may have a low price to book ratio but it may deserve to have a low price to book ratio. Such stocks are known in the trade as ‘value traps’, and they should be avoided.


By considering in detail all sorts of other aspects that drive a company’s longer-term performance, such as industry trends, barriers to entry, balance sheet strength, free cash flow, to name just a few.

In a later edition of Benjamin Graham’s second classic, The Intelligent Investor, first published in 1949, Graham noted that IBM was a wonderful investment opportunity.

“Smart investors”, he wrote, “would long ago have recognised the great growth possibilities of IBM”, but “the combination of [IBM's] high price and the impossibility of being certain about its rate of growth prevented [investment funds] from having more than, say, 3 per cent of their funds in this wonderful performer”.

There are two key things that one can learn from this.

First, a value stock does not have to be cheap in absolute terms. IBM wasn’t, and Graham even uses the term ‘growth possibility’ to describe it – but ‘growth’ is supposed to be the antithesis of ‘value’, I hear you say. Second, even smart investors can be too timid when it comes to portfolio concentration – 3 per cent can hardly be called ‘high conviction’.

At Seneca, we are value investors, but we are not scared of buying stocks that are not cheap in absolute terms. We consider various other factors such as balance sheet strength, return on capital, and industry trends, and if we determine that a stock is cheaper than it should be – in other words, has a dividend yield that is higher than we think it should be – that is good enough for us. Nor are we scared of being high conviction – we only hold around 20 stocks in the UK equity portion of our portfolios.

As a pure multi-asset fund manager, we are trying to add value to our portfolios not just in UK equities, but also in overseas equities, fixed income, specialist assets and indeed tactical asset allocation. We do this by taking the central principle of ‘value investing’ – buying things cheaply – and applying it to these other areas. We call this ‘Multi-Asset Value Investing’ and I will be writing about it in more detail in later blog posts.

Peter Elston is chief investment officer at Seneca Investment Managers. The views expressed above are his own and should not be taken as investment advice.

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