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How I use the hidden value effect to generate higher returns

There’s a very interesting premise I think we all need to know about called the ‘value effect’. It’s simply this: buying stocks with lower valuations tends to earn investors better returns over the long term.

It’s not a new concept. In fact FTSE operator Russell tells us the theory is “one of the most well studied and evidenced market factors in equities.”

So how does it work? The value effect says that over time, a portfolio of value stocks will earn you a return that beats a portfolio of growth stocks.

Value stocks have a low market value relative to their fundamentals, like a company’s earnings per share or how much debt it holds. Growth stocks have a high market value relative to their fundamentals.

Tobin Q Theory

First proposed in 1966 and popularised by Nobel Prize-winning economist James Tobin, Q theory focuses on the relationship between how the market values a stock and its intrinsic value.

It states that you can work out how overvalued or undervalued any stock is by adding up how much it would cost to replace all of a firm’s assets. Add the market value of a company’s equity to its liabilities, then divide that by a combination of the net asset value of that equity and liabilities. The number that comes out of the sausage-maker at the end is your Q rating.

A high Q rating of more than 1 tells us that it would cost a company more than the value of its shares to replace all of its assets. This stock is overbought, or overvalued. A low Q rating of between 0 and 1 implies the opposite, that a company could replace all of its assets without exceeding the value of its stock. This stock is undervalued.

Happily, we don’t have to dig through hundreds of web pages or break out our calculators every time we want to find out the right numbers. I use www.uk.advfn.com.

For example, Lloyds is by a considerable margin the most traded FTSE 100 share. The Q rating for Lloyds is 0.04. That’s pretty close to 0, so we can say with some confidence that Lloyds stock is undervalued. It may seem obvious for a share that in 2015 was trading at 95 times earnings, and is now at 9 times earnings.

That said, my Foolish colleague Royston Wild has covered Lloyds pretty extensively and he reckons it’s a value trap.

That’s biased

One of the major things we’re battling against as value investors is our own biases. The main one we have to watch for is confirmation bias. This is when investors act irrationally based on new information because they seek out data that confirms our previous beliefs and discard information that goes against them.

How to beat confirmation bias? Knowing it’s there is half the battle. Look out for contrary information about the stocks on your watchlist and keep an open mind.

Context, we believe, is key to analysing the incredible amount of market data we’re faced with to sift out the relevant from the irrelevant. So it is quite difficult to put aside the sum of our accumulated knowledge. But try we must. I say read often, and read carefully.

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.