Relative Value

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Relative Value

Value strategies roughly divide into the relative-value and absolute-value camps. Not surprisingly, there are a lot of variations within each group.

The Relative-Value Strategy

Fund managers practicing relative-value strategies compare a stock’s price ratios (such as price/earnings, price/book, or price/sales) with a benchmark and then make a decision about the firm’s prospects. In other words, value is relative. Absolute-value strategies, however, use what a company is worth in absolute terms rather than a benchmark. These benchmarks can include one or more of the following:

• The stock’s historical price ratios. Companies selling for lower ratios than usual can be attractive buys for value managers. Often, these companies’ prices are lower due to some "bad news," to which the market often overreacts. Some value managers have picked up certain companies as a string of recent earnings misses have soured investor sentiment on the firm.
• The company’s industry or subsector. A manager may believe that a company is undeservedly cheap compared with its competitors. For example, a value fund will look for stocks on an industry-by-industry basis, seeking companies that are trading cheaply relative to their industry peers. The fund will also limit sector bets to within a few percentage points of the Russell 1000 Value Index.

Funds that look for companies that are cheap relative to their industry peers may well take on more price risk than absolute-value funds. For example, in early 2000, even though the technology sector as a whole was dramatically overvalued, a relative-value manager, or a manager that needed to maintain a certain percentage in each sector according to an index benchmark, might have continued buying technology stocks that appeared cheap relative to other technology stocks. Meanwhile, value managers following a different approach might have avoided technology altogether.

• The market. In this case, managers look for companies that appear attractively valued relative to the broader equity market, not just their industry peer groups. For such a manager, technology stocks wouldn’t have been a likely place to find bargains in early 2000, even though many would have filled the bill for a manager seeking companies that were merely cheap relative to their industry peers.

For these managers, a company may be attractively valued because of issues specific to its own operations that have depressed its share price or because it’s in an out-of-favor industry. This scenario is common with cyclical sectors, such as industrials or consumer discretionary names.