Relative vs Absolute Value Investing | Exposing the Truth

Relative vs Absolute Value Investing: Exposing the Truth

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While we focus exclusively on dividend-growth investing at Wicked Capital, our approach is predicated on a value foundation. As such, we intentionally dedicate a significant amount of time to covering the fundamentals of value investing. A critical component of value investing is how you determine value. In this article, we will answer the pivotal and hotly-debated question: Does a relative or absolute value investing strategy provide the best results—meaning outperformance (or alpha)?

Traditional value investing has followed in the footsteps of Benjamin Graham—chiefly viewed as the father of value investing. Graham utilized an absolute value approach to his investing. However, in recent decades, the concept of relative value investing has arisen and grown in popularity—I would argue due to its closer alignment with a growth-investing approach and/or mindset.

Regardless of the reasons behind its meteoric rise in use among value investors, the million-dollar question remains: Does this neo-value approach generate superior performance? Or, is it just another short-lived fad, whose flash and hype merely conceal the inconvenient truth that it actually provides investors with little, if any, added value (alpha)?

In this article, we’ll examine both strategies to expose the truth and reveal which approach—relative (neo) or absolute (traditional)—is your best option for long-term value investing success.

Table of Contents

Relative Value Investing

At its core, relative value investing is predicated on mean reversion. As such, it holds that if a given stock is trading below some relative measure, it should return to its historical range.

Stated differently, a stock is considered undervalued (overvalued) when it is trading below (above) its own historical trading range, the trading range of its peer group, or any other relative proxy for fundamental value.

Typically, relative value investors utilize price-to-earnings (P/E or PE) ratios or yields to determine this relative valuation—though there are many other options out there.

There are two issues inherent in using relative metrics tied to a stock’s own historical trading range.

Weakness #1 with Relative Value Investing: Anchoring

A significant and material problem inherent in relative valuation is that it requires knowingly and intentionally anchoring to historical data—something almost everyone (in any other context) would agree is a bad idea. And yet, relative value investing requires and depends on it!

It is critical to remember that past performance is NOT indicative of future performance. Just because a stock traded in a certain range in the past does not mean it will necessarily revert to that range again. It may… but it may not. What matters are the underlying fundamentals.

To learn more about the danger of anchoring (and other investing pitfalls), I encourage you to read my article 4 Perilous Pitfalls to Avoid with Dividend-Growth Investing.

While I have advocated for the use of relative metrics (e.g., Dividend Yield: What Every Dividend-Growth Investor Needs to Know) as a screening tool or secondary check, I would also strongly discourage the use of such metrics a primary component of your LT investing process—and absolutely discourage it as a trigger to buy a security.

Weakness #2 with Relative Value Investing: Mean Reversion

The problem with mean reversion is that it is based on a distribution curve. If the distribution’s population is fairly normal, then most points will occur near the mean. Points further from the mean (known as the tails) will occur with far less frequency. This means that under normal circumstances, as relative metrics (e.g., PE and yield) fall (or rise) away from the mean, probabilities imply that they will inevitably return to the mean.

However, this assumes that the sample (the historical range being analyzed) remains valid in the future. Unfortunately, with stocks, this is a dubious assumption—stocks can be repriced and multiples (such as PEs) can expand and contract across industries, sectors and/or the broader market. This can materially alter the makeup of the data set moving forward and shift the distribution (and mean) upward or downward. Again, this is the danger with anchoring!

Without sound fundamental analysis, it is impossible to know whether a stock’s relative valuation move is a case of valid repricing or if it is likely to revert towards its current mean—historical data simply can’t tell us that.

The Bottom-Line with Relative Value Investing

Again, relative metrics have their place in value investing. Like a house for sale, it is always helpful to know how a stock is priced relative to its history and its peers (neighborhood). However, this knowledge should always be viewed as secondary validation.

A house that has become “cheap” compared to its historical price range and in relation to other similar houses in the area may be a great value opportunity—or it may be cheap for a reason. Closer examination (like fundamental analysis) may show that it is in need of major and costly repairs—indicating a valid repricing rather than a value opportunity.

Again, relative metrics can be a great screen, filter, or secondary indicator… but they should not be relied upon for actual stock selection—nor as a buy/sell trigger.

Absolute Value Investing

On the other hand, absolute value investing is predicated on an absolute measure of value—a stock’s intrinsic value.

Stated differently, a stock is considered undervalued (overvalued) if it is trading below (above) the discounted value of its future cash flows based on a given required rate of return and any additional margin of safety (MOS).

This strategy argues that a given stock will eventually appreciate in value because it is worth more than its current price reflects—not simply because we think others will be willing to pay more for it because they have in the past. In other words, it is predicated on an absolute value rather than a relative multiple that can fluctuate.

Furthermore, absolute value investing provides a critical additional benefit—a much more well-defined margin of safety. With relative value investing, you have no idea what the floor is—meaning, how far out of a range a given stock can fall. With absolute value investing, you know that a stock is trading below its actual intrinsic value—with your required rate of return and additional MOS factored in. This reduces the potential downside risk—or at least defines it (i.e., we at least know what the risk is).

What Does the Data Say about Relative vs Absolute Value Strategies?

We’ve seen what each strategy is based on—and that each provides some benefits. So, which one provides the best overall performance for the LT value investor?

It just so happens that Nicholas Anderson examined the performance of various relative value investing strategies using stocks from the S&P 500 between 1990 and 2014—and compared those results to a traditional absolute value investing strategy.

In his paper “The Performance of Relative-Value Equity Strategies,” Anderson finds that an absolute value investing strategy not only outperforms all the relative strategies tested… but does so by a significant margin!

Specifically, he states that the long-only absolute value strategy “provides the most robust returns of any of the strategies.” Furthermore, it outperforms both the S&P 500 Total Return Index and the S&P Equal-Weight Index. In fact, the absolute value approach proved robust even when controlling for CAPM and Fama-French 3-factor exposure.

Furthermore, the absolute value strategy produced a significantly higher Sharpe ratio than the relative strategies tested. This implies that, while the absolute approach was riskier (as technically defined by a higher annualized standard deviation of returns), the higher returns more than offset the additional risk. In other words, an absolute value strategy produces higher returns even when adjusted for risk.

Interestingly, the relative value strategies all produced the same Sharpe ratios—inline with that of the underlying index. This means that while the relative value strategies did manage to produce a slightly higher return than the passive index, when you adjusted for risk, they produced no added value (alpha).

Thus, the empirical evidence strongly supports the argument that absolute value investing is the best approach for long-term retail investors—including dividend-growth investors. This conclusion is further supported by data regarding the value-growth spread.

Caution: Absolute Value Investing Is Only One Part of the Overall Process!

While the data demonstrates that absolute value investing provides us with outperformance, it presents us with (1) both an efficacy and efficiency challenge and (2) an opportunity for increased performance.

First, it is impractical to manage a portfolio that contains every undervalued stock. Furthermore, the amount of time required to determine absolute valuations for a large number of stocks is prohibitively high.

Second, not all absolutely undervalued stocks will ultimately produce great returns. In other words, valuation, in and of itself, cannot fully predict the size and scope of future performance.

These factors lead to some important realizations when it comes to our investing process:

  • We need to be able to quickly screen/filter for value opportunities.
  • We need a process that more effectively predicts future performance.
  • We need to know when to buy/add the best stocks.

Step One: Screening for Value Opportunities

The first step is reducing the number of potential stocks via screening. After all, we have limited resources and cannot evaluate nor hold everything.

[If you don’t want to do analysis or prefer to hold large numbers of stocks, then you should just consider being a passive investor who buys and holds an index.]

The strength of relative value metrics is that they are quick and easy to calculate. The data is both simple and readily available. As such, relative value strategies are perfect for screening the universe of potential stocks and filtering them down to a workable sample size. Furthermore, most screeners offer a number of relative value metrics.

This works well because—even when using an absolute value approach—we can pretty much eliminate stocks that are trading at or above their historical ranges. It is highly unlikely that these will provide high-levels of absolute value opportunity.

Step Two: Determining Future Company Performance

As I noted, valuation alone does produce alpha… but only over large populations (meaning extreme diversification). When we have to pick a smaller number of individual stocks for our portfolios, the standard deviation of returns (RISK) rises when valuation is used in isolation. This means we can do really great… or really bad.

As such, we need a better process for determining future performance potential. What is that process? FUNDAMENTAL ANALYSIS!

Value investing—including dividend-growth investing—is, always has been, and always will be predicated on fundamental analysis! As Warren Buffett is fond of saying, “Price is what you pay, value is what you get.” Fundamental analysis tells us what value we are getting—it is the foundation of our investing thesis.

Cheap does not equal great. Quality companies that are undervalued equal great investments. And it is fundamental analysis that enables us to identify quality companies. This greatly reduces our risk of getting caught in value traps—cheap companies that are cheap for a valid reason (i.e., they are not undervalued but being correctly priced by the market).

The second step in our process should always be to take our filtered list of potential value plays and select the best quality companies based on their fundamentals.

There are an infinite number of ways to perform fundamental analysis. One possibility is to use some form or variation of the Piotroski F-Score. To learn more about this approach, I recommend reading my article Can F-Scores Really Improve Your Dividend-Growth Investing?

Step Three: Determining When to Pull the Trigger and Buy

Once we’ve identified the best value opportunities (aka quality companies), we must then determine when we should buy them. This is where absolute value enters the picture!

We must determine an absolute intrinsic value for each of our selected companies. I recommend using a discounted cash flow (DCF) model—and prefer to use free cash flow (FCF) or owner’s earnings rather than accrual-based earnings off the income statement. This approach allows us to calculate an intrinsic value based on a required rate of return—providing a margin of safety. Furthermore, we can then add an additional margin of safety if desired.

To learn more about calculating absolute intrinsic valuations, I encourage you to read my article How To Easily Value Dividend Stocks Using Discounted Earnings. If you’re interested in exploring the benefits of using FCF or owner’s earnings, checkout my article Cash Flow vs Net Income: What’s the Best Way to Value & Invest?

This absolute valuation provides us with a trigger point—one that is unemotional and one that is not relative. When one of our selected companies trades below this absolute value, we initiate our position.

Obviously, price can continue to decline (and typically does with value investing) before the market recognizes what we’ve identified, and things begin to get better. For this reason, it may be beneficial to scale into your position over time—lowering your cost basis and increasing your potential return.

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The Big Picture with Value Investing

In the end, we want to develop and consistently employ a (1) quantitative and (2) absolute value-investing process.

This will provide us with a long-term investing approach that:

  • Delivers Consistent, Long-Run Alpha
  • Mitigates the Danger of Irrationality, Emotion, and Subjectivity
  • Reduces Risk via Margins of Safety

The second benefit listed above is particularly critical given the growing wealth of information about behavioral finance. Our goal should be to (1) limit our behavioral missteps and (2) capitalize on the behavioral errors of others. This requires a process that is systematic, logical, repeatable, consistent, methodical, and unemotional.

Value investing works. It works because it is extremely difficult for most folks to do!

This is why Benjamin Graham always insisted that “individuals who cannot master their emotions are ill-suited to profit from the investment process.”

An investing process that combines an absolute value strategy with effective fundamental analysis is the key to accomplishing these three key things over the long run.

Quantitative Absolute Value Investing

Conclusion

There are two general approaches to value investing: relative value and absolute value.

While relative value strategies have their place (as screeners and filters), we need a process that is predicated on absolute value and effective fundamental analysis.

The data clearly demonstrates that an absolute value strategy significantly outperforms relative value strategies—even when adjusted for risk, CAPM, and Fama-French 3-factor exposure.

We must resist the urge to both anchor to past performance and expect mean reversion that is not backed-up by our fundamental analysis and absolute valuation.

While our focus in this article has been primarily on pure value investing, everything presented is entirely applicable to dividend-growth investing. An income investing approach allows us to maintain a three-fold performance focus: (1) income (dividends), (2) income growth (dividend-growth), and (3) capital appreciation (the value force-multiplier). We simply add the dividend component to our screens and fundamental analysis.

If you’re interested in dividend-growth investing and/or looking for valuable insights into value investing, then you’re in the right place!

At Wicked Capital, we focus exclusively on helping others become as successful as possible with dividend-growth investing and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!

Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that DGI portfolio with a solid process and winning long-term investing mindset!

Doug

Doug is the founder of Wicked Capital. He holds an MBA, BBA (Summa Cum Laude), and AAcc from Liberty University and has over 20-years of corporate finance, accounting, and operations management experience--spanning the public, private and nonprofit sectors. He is a member of Sigma Beta Delta International Honor Society in Business Management and Administration, Delta Mu Delta International Honor Society in Business, and Tau Sigma Academic Honor Society. He is also proud to have served his country as a member of the 82nd Airborne Division. His professional wheelhouse is corporate financial reporting, analysis, and forecasting—buoyed by his passion for fundamental analysis and valuation. Doug has been actively engaged in trading and investing for several decades, with a focus on value and dividend-growth investing. He has authored several books and, when he's not busy living the corporate dream, trading and managing investment portfolios, he enjoys playing the drums and spending time with family--especially in the Outer Banks of NC.

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