It has long been understood that cheap stocks have a tendency to outperform expensive stocks in the stock market. While this is not true every single year, over almost every 3 year cycle in the stock market cheap (or value) stocks outperform. This phenomenon has created the cult of 'Value Investing' born of the writings of Benjamin Graham and the phenomenal success of it's arch proponent Warren Buffett.
The Stockopedia Value Rank is a blend of several of the most important value ratios and has been found, when used in a portfolio approach, to outperform the use of any of these value ratios on their own.
It should though be noted that 'cheap' stocks are often distressed, junk or low quality stocks and can often be highly volatile as a result - so one should be careful in the very highest ValueRank companies. Investing in these kind of stocks is known as 'bargain' investing and can require a lot of finesse. A safer way to invest in value stocks is to find the best quality value stocks or value stocks whose share prices are turning around - filtering the wheat from the chaff. At Stockopedia we always recommend the rule of thumb of twinning the Value Rank with either the Quality Rank or the Momentum Rank to help avoid value traps.
Our ValueRank is based on a composite of the following Value Factors:
- Price to Book Value
- Price to Earnings
- Price to Free Cash Flow
- Dividend Yield %
- Price to Sales
- Earnings Yield %
Consistent with the value investing philosophy, we use historic ratios for each of these metrics, rather than factoring in analyst forecasts. Each company in the market is ranked from 1 to 100 for each of these value ratios and a composite score is calculated as the weighted average of all valid values. The ValueRank™ is then calculated between zero and 100 for this composite score, where 100 is best and zero is worst.
This score should be contrasted within our QualityRank, MomentumRank and GrowthRank.
Composite value scoring systems have been used successfully by many investors since Ben Graham originally designed his 'multiplier' that blended the P/E ratio and P/B ratio. This work has been extended by data driven investors for decades, and composite value scores & indices have been published by institutional investment platforms like Starmine (Thomson Reuters), Morningstar, S&P and Societe Generale. One of the most classic and inspiring studies is by James O'Shaughnessy in the 4th edition of What Works on Wall St in which he showed that composite value factors based on an average ranking of 6 ratios - P/S, P/E, P/B, P/CF, EBITDA/EV, and Shareholder Yield (dividends+buybacks) - dramatically beat the market. These ideas can be seen backtested and further verified in the excellent "Quantitative Value" book.
Given that during different market environments different value ratios perform better it's perhaps unsurprising that if you buy the cheapest stocks in the market based on this composite measure you can achieve better overall returns with less risk over the long run than using the ratios individually.
Indeed between 1964 and 2009 O'Shaughnessy showed that using Price/Sales alone - the best 10% of stocks by Price to Sales rebalanced annually returned 14.49% with a standard deviation (volatility) of 20.68%. But by using the composite value factor instead the return was improved to 17.3% and the standard deviation reduced to 17.1%. O'Shaughnessy suggested that these returns could be even further improved by filtering the universe further for higher quality stock. We suggest using a combination of the ValueRank™ with the QualityRank™.
You can read a full discussion of these ideas in this article about Blended Value Ratios.