Value investing isn't as easy as you might think.
That's the basic message conveyed by U-Wen Kok, Jason Ribando and Richard Sloan in their paper "Facts about Formulaic Value Investing," which was recently published in the "Financial Analysts Journal."
Their beef is with strategies that scan for stocks with low price-to-earnings or price-to-book ratios, and upon finding them, declare the stocks offer compelling value to investors. Such quantitative value-seeking strategies have become increasingly common, but the authors argue that all they do is "systematically identify companies with temporarily inflated accounting numbers" and hence "should not be confused with value strategies that use a comprehensive approach in determining the intrinsic value of the underlying securities."
For instance, an investor who is looking to buy undervalued stocks might select one with a low price-to-earnings ratio. The implicit hope is that the price would rise such that its price-to-earnings ratio will
A study performed by the authors "shows strong evidence of mean reversion for the cheap stocks," but also found that "all the mean reversion in the high forward-earnings-to-price ratio is driven by forecasts of falling earnings. Stocks with high forward-earnings-to-price ratios are not cheap stocks; they are stocks that temporarily have forecasts of high earnings."