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51

$700,000

$600,000

$500,000

§ $400,000

$300,000

$200,000

$100,000

Average Annual Retums

Low P/E

19.0

Low P/CF

Low P/BV

LowP/D

16.1

Market

14.9

Figure 7-4

Four Flavors of Value

1970 - 1996

1971

1976

1991

1981 1986

YEAR

Initial Investment of Ten Thousand Dollars in 1970 with Annual Rebalancing

1996

LowP/E

$ 708,000

Low P/CF

........ b

$ 572,000

Low P/BV --.

$ 685,000

LowP/D ---d

$415,000

Market

$ 289,000

isnt easy. Remember, according to Vanguards John C. Bogle and the performance figures in chapter 1, only about 10% of managers are able to accomplish this in any decade.

Figure 7-4, talcen from a study I did in collaboration with Eric Lufkin, shows how effective contrarian value strategies have been for the 27 years ending December 31, 1996. The study measures the Compustat 1500-the 1,500 largest stocks publicly traded. Four separate value measures were used: low P/E, price-to-book value (P/BV), price-to-cash flow (P/CF), and highest yield (lowest price-to-dividend or P/D). For each measure, stocks were divided into quintiles stricdy according to P/E, P/BV, P/CF, and price-to-dividend, and the results were calculated annually throughout the study. The chart shows the retums against market using each of these strategies for the 27-year period.

Value strategies work with a vengeance! All four outperform the averages, and the retums of three of the strategies are outstanding. Ten thousand dollars invested in the bottom 20% of P/Es in the Compustat 1500 in 1970 would be worth $708,000 at the end of 1996 (all figures



include reinvested dividends), about times the $289,000 retum of the market.

Low price-to-cash flow (P/CF), taken strictly from the statistics available from Compustat (thus excluding all the high octane adjustments claimed to soup up performance), also worked just fine. Low price-to-book value (P/BV), a favorite of Benjamin Grahams, was a hairs breadth behind low P/E, but ahead of the other two strategies for the period and 8 1 ahead of the market.

Finally, lets move on to the price-to-dividend investment strategy. This value method is a littie different from the other three. Normally, high dividend yields are found in utility and other industry groups, which are not expected to have rapid appreciation. On the opposite side of the scale, stocks that pay small dividends or none at all are usually found in rapidly growing industries. Instead of paying dividends, the money is held back to finance rapid growth. There has always been a good deal of controversy about whether stocks with high dividend yields outperform the averages.

The answer is su rising. High-yield stocks out-distanced the market by 44%-or 1.5% per year, although trailing the other three value measures. Ironically, though large numbers of investors buy large dividend payers for income, this method is probably most suitable for tax-free accounts. In a high tax bracket, the performance advantage over the market will decline fairly significantly, because a large part of the retum is dividends, which are taxable.

Another reasonable question is, how did the favorite stocks perform by the same yardsticks? Badly. Regardless of which value measure I used, none of the favorites came close to beating the market over the 27-year period. Ten thousand dollars invested in the highest P/E group retumed $137,000, only 47% of the $289,000 retum of the market. The same amount in the highest price-to-cash flow category and highest price-to-book value retumed $99,600 and $117,000, respectively. It was just as bad for the low-yield and no-yield group. Ten thousand dollars invested in this sector retumed $102,000, a dismal 35% of the market retum.

But the story doesnt end here. Most investors want more than just to increase their nest egg in a rising market. As important, they would like to keep it intact when the bear growls. Momingstar, Lipper, and The Forbes Annual Mutual Funds Survey, among others, for example, rank mutual funds on how they perform through several bear markets.

To find out whether our contrarian strategies worked in down markets, we measured the retum of the value stocks in each of the four categories for all down quarters in the study and then averaged them. As



Figure 7-5

When the Bear Growls Bear Market Retums 1970 - 1996

□ LowP/D Low P/CF Low P/BV Low P/E h Market

Figure 7-5 shows, the value strategies all did better than the averages in die down markets, through the same period (1970-1996).

While the market dropped 7.5% in the average down quarter, low P/E, price-to-cash flow and price-to-book value all fell less, under 6.2%. The best performers, as you might expect, were the high yield stocks, declining only 3.8%, or half as much as the market.

As you also probably guessed, the high-P/E, high-P/CF, high-P/BV, and low-yield stocks were hit hard. High-P/E, high-P/BV, and high-P/CF were down about 9M%, 2% more than the market averages. The worst retums by far were the stocks paying low or no dividend, which were down 12.2% quarterly, versus 7.5% for the market.

Value stocks, then, not only provide higher retums in a rising market, but also star on the defense. The value strategies, originally presented by Ben Graham and other market pioneers, played out at least as well, and perhaps better, than they would have imagined.



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