How I Incorporate Value Into My Strategy

Over time, I’ve evolved how I incorporate value into my investing strategy. For a long while, I used absolute limits on the price-to-book (P/B) and price-earnings (P/E) ratios. Then I switched to my current practice of using relative valuations incorporating the price-to-book, price-to-sales (P/S) and price-to-cash-flow (P/CF) ratios. This is the same strategy used for VMQ Stocks.

Before I explain why I think my newer method is better, I want to step back and discuss the bigger picture. Value investing—the concept of buying stocks at bargain prices—works if you are committed to and disciplined about using it. A good analogy is dieting. While there are arguments about how much protein you should consume relative to carbohydrates, dieting is essentially all about consuming fewer calories than you burn. Value is the same way; there are nuances to consider but it’s more important to simply avoid overpaying when buying a stock.

As far as the nuances are concerned, there are two to focus on. The first is what ratios you use. The second is choosing between absolute and relative valuations.

In terms of ratios, most will help you separate the cheap stocks from the expensive stocks. It doesn’t matter if you use book value, sales, cash flow, earnings or EBITDA  (earnings before interest, taxes, depreciation and amortization) as your basis. With any of these measures, you’ll get higher returns by favoring stocks with lower valuations and eschewing those with higher valuations.

While you could pick one ratio, I think there is an advantage to combining them. Combining valuation ratios provides confirmation about a stock being cheap or expensive. Rather than relying on one single indicator, you’re getting several signals potentially flashing the same sign: the stock is cheap or it’s not. When the indicators give you differing signals, you can average them to get a consensus. If one ratio says the stock is cheap, another says the stock has fair valuation and a third says the stock is expensive, then the average of all three implies that the stock is fairly valued. This simple type of analysis can be very effective at helping you gauge a stock’s attractiveness.

An easy way to do this is to look at the relative valuations, an indicator that we, at AAII, provide and built into VMQ Stocks. A relative valuation compares a stock’s valuation to the valuations of all other stocks. It’s calculated by placing every stock into a percentile ranking, from lowest to highest. A stock with a price-to-sales ratio of 0.7 has a valuation ranking in the lowest 25%. A price-to-sales ratio of 1.9 ranks a stock at the 50th percentile, while a price-to-sales ratio of 4.2 puts a stock in the expensive 75th percentile. Relative valuations work well because you can simply calculate the average rank to determine if the stock has a below-average valuation or an above-average valuation. Plus, using relative valuations in a screen always ensures you’ll find investment candidates (assuming your other criteria are not too restrictive).

The alternative is to use absolute valuations such as a price-earnings ratio no higher than 10.0. The challenge with using this method is potentially not identifying enough qualifying stocks from which to build a diversified portfolio. During extended bull market periods when valuations rise, you’ll end up with fewer stocks to choose from. I used to use absolute valuations; I stopped doing so because I found relative valuations gave me more options from which to choose.

My strategy is the same one we use in VMQ Stocks. The VMQ strategy seeks out stocks whose combined price-to-book, price-to-sales and price-to-cash-flow ratio rankings are below average. This allows us to cast a wider net for investment candidates without overpaying for the stocks we do buy: a win-win situation.