The Value Effect - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 1 March 2014
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- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
In an article 3 weeks ago, we talked about Benjamin Graham's philosophy towards investing. The basic idea is to buy stocks trading below their intrinsic value and use a quantitative approach to do so. This means that we should buy companies that have low price to earnings ratios (P/E) and low price to book (P/B) ratios. If we accumulate a portfolio of these types of companies, we can expect to outperform the market over time.

The philosophy behind this approach is that markets are irrational in the short term, but are efficient in the long term. This means that in the short term, market prices can fall below their fundamental or intrinsic values, perhaps due to negative sentiment or other external factors. However, in the long term, prices converge to their intrinsic values. This process allows us to buy value stocks when they are cheap, and sell them at a profit in the future.

Now we understand why this approach should work in theory. But does it work in practice? The answer is a resounding yes. Numerous studies over the years have confirmed what is called the 'Value Effect'. The value effect is the tendency for companies with low P/E ratios and low P/B to outperform the market over time. It has been shown to hold for stock markets around the world, and has held over many years.

The value effect is analogous to Benjamin Graham's approach. Using only various accounting ratios and without considering qualitative factors of a company, we can find stocks that outperform the market. Benjamin Graham's ideas were published in a text written in 1934 called 'Security Analysis'. This is one of the first books ever written on value investing, and is remains as relevant today as it was back then.

In practice, no strategy is without risk. Buying value stocks is not a free lunch, because free lunches do not exist. What we find in stock market data over time, is that in some years value stocks outperform the market, and other years they underperform the market. So there is certainly risk involved. However, over longer periods of time, value stocks consistently outperform the market average.

They key to taking advantage of the value effect is patience. Value stocks outperform the market, but this happens over long periods of time. If we look at the individual stock level, companies that trade below their intrinsic value may take time before they recover to their true values. And this is why the value effect has been shown to work over long term holding periods.

Going forward, we can expect value stocks to outperform the market in the years to come, over a long term period. Of course there are no guarantees when it comes to investing, but if historical data is our guide, the odds are very much in favor of Benjamin Graham's approach to value investing.

We are asking the following question in the Equitymaster club forum: Do you expect the 'Value Effect' to continue over the year to come? Please login and post your views.

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is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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2 Responses to "The Value Effect"

Borkar M.R.

Mar 1, 2014

Since Value Effect becomes visible over a long period, in my view a period of not less than five years, to expect it to be visible is rather "speculative". The fundamentaly good companies' performances have been under stress in the last 5 years 2008-2013 hence the value of these cos. might have
gone up just marginally and considering 2013-14 year going to be little unstable, the value investing will be with little extra risk, I mean the waiting period will be little longer. One may not lose but the gains will not be marked. - Borkar

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SANTOSH ARORA

Mar 1, 2014

"the 'Value Effect'. The value effect is the tendency for companies with low P/E ratios and low P/B to outperform the market over time. It has been shown to hold for stock markets around the world, and has held over many years. === IT WAS TRUE WHEN THE MARKETS WERE STABLE. TIME HAVE CHANGED & THIS DON'T HOLD AS IT DEPENDS ON THE PRODUCT & IT HAS POPULARITY OF ITEM AS WELL REASONABLE COST.

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