What are value stocks

In my mind, value stocks are buying stocks at a discounted value.

This is very easy to imagine in real life. For example, at the end of winter, all the winter coats are discounted by over 50%. The same winter coat that was worth $200 in November, at the end of January is being sold at only $50.

I remember one time, at the end of the winter I bought a coat at Walmart for only $7. I used that coat for 5 years. I feel that I got great value from that coat. I am sure that many of you have similar stories to share, where you saw something for sale at a deep discount and took advantage of that opportunity.

The same idea applies to stocks. Stocks fall out of favor for one reason or another. The mechanics are hard to understand because most of us don’t know how to read financial statements and we don’t know how to value stocks, but be aware that the same logic applies. Stocks fall out of favor only to become desired stocks a few months later.

The big secret is not to buy individual stocks. The secret is to buy an index fund or an ETFs composed of value stocks. In this way, we know that some of those value stocks will fail (like Blockbusters, or Kodak), but some will come back to be loved (like Microsoft). If any of those come back to be loved, the value of the index or ETF will go up, and in the long run, it could grow at a faster rate than the S&P 500.

The stock market works in cycles. Sometimes growth stocks are in favor, some times value stocks are the ones that outperform the market. In this link we can see a report of how value stocks perform when compared with growth stocks and how from cycle to cycle they exchange leadership.

Fortunately, in the United States, there are asset classes called “Value Stocks.” These value stocks are assembled together in several indexes or ETFs and made available to the consumer through different financial institutions.

In general, over the long periods of time, value stocks, have produced better returns than the S&P 500. The big drawback is that value stocks have higher volatility and bigger negative years.

Searching the best value for your money

Let’s go to my new favorite website to compare how different returns would have worked out.

My favorite website is called Portfolio Visualizer and it allows me and you to make assumptions about the stock market and see the results right away.

The only drawback of the following experiment is that we can only see back 46 years. From January 1972 to now March 2018.

Let’s assume that we have $100,000 and we can invest it in

1. The Total U.S. market
2. Big cap value stocks
3. Medium cap value stocks
4. Small-cap value stocks.

Here it is.

1. Total U.S. Stock market:

If we would have invested $100,000 in January 1972, today we would have $944,467. Not bad. Almost one million dollars.

2. Big Cap Value:

If we would have invested $100,000 in January 1972, today we would have $1,424,499. Very nice. Almost 50% more than being invested in the total market.

3. Medium cap value:

If we would have invested $100,000 in January 1972, today we would have$3,090,162. This is very sweet. About 200% more than in the total U.S. index.

4. Small-cap value:

If we would have invested $100,000 in January 1972, today we would have$4,742,754. Extraordinary. Over 300% of the total U.S. stock market return.

The Gap between Total U.S. Market and Small-cap value

If you notice, all these graphs are extremely similar to each other. All of them had a big drop on 2008 and a big run-up after 2009. The correlation of the small-cap value to the total U.S. index is 88%. However, a regular out performance of a few percentage points for most years created this great gap between $944,467 for the Total U.S. and $4,742,754 for the small-cap value. A big difference of $3,798,287.

The other thing to notice is that the small the stock in the asset class, the higher the total return.

How to Invest in Value

Fortunately, companies such as Vanguard, have found a way to lump value companies together. They do this by using metrics such as price-to-book-value (P/B) ratio and the price-earnings (P/E) ratio.

When we lump all these companies together we can find many ugly ducks, but also some gems which will increase the average by a few points year after year.

Go to Vanguard or to any other ETF provider and look for value stocks.

In this graph, we can see how a hypothetical investment of $10,000 10 years ago would have done.

Just be careful. Be sure you can withstand the volatility. Imagine it’s the year 2008. Can you tolerate that kind of drop? If you can’t, don’t even think about investing in value.

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