Why value investing fails with the wrong yardstick

• Published : August 06, 2026

Value investing fundamentally relies on making sound comparisons to identify opportunities. However, significant problems arise when these comparisons are ill-chosen or inadequately defined.

For instance, a market-wide value screen can look tidy. Sort companies by a single valuation ratio, pick the lowest-ranked stocks and the portfolio appears disciplined. While the screen may create the impression of analytical rigour, such an approach lacks the nuanced comparison necessary for truly effective value investing.

Consider this. A lender and a cement company may both report similar profits and trade at similar valuation metrics. However, the similarity ends there. That’s because the lender’s earnings depend on credit costs, regulation and capital adequacy, whereas the cement company’s profits depend on capacity, fuel costs and the construction cycle. To rank both on the same raw multiple is to pretend that the same accounting line carries the same economic meaning.

This reflects a central flaw in value investing when industry context is neglected: investors are not simply acquiring inexpensive stocks, but are also making improper comparisons across fundamentally different businesses. Such misaligned evaluations can undermine the effectiveness of value investing by obscuring meaningful distinctions in economic realities.

Why the same valuation ratio can mislead

Value investing starts with a sensible instinct: do not overpay. Where it gets challenging is in deciding what “cheap” means.

P/E is useful when earnings provide a reasonable guide to earning power. In cyclical businesses, that assumption can be dangerous. Profits may be inflated near the top of the cycle. A low P/E at that point may not signal an opportunity. It may signal peak earnings.

P/B has a different weakness. It can be useful when tangible assets matter. But it is less useful when the business depends on software, distribution or brand strength. In such cases, book value may capture the legal accounts while missing much of the economic value.

Enterprise-value measures may work better for businesses where debt, depreciation and operating assets shape returns. Even here, care is needed. A utility and a commodity producer may both require significant capital spending, but their cash flow stability can differ significantly.

For lenders, the balance sheet is the business. Loan quality and capital strength matter more than industrial valuation measures.

So, as you can see, a ratio has no independent wisdom. It becomes useful only when it is applied to the right kind of business.

Why industry context matters

Industry context improves the quality of the comparison by allowing investors to evaluate companies within relevant peer groups and avoid misleading cross-sector comparisons. For example, comparing a cement manufacturer to other firms with similar capital intensity and cycle-driven earnings, rather than to asset-light technology businesses, ensures that valuation metrics such as P/E or EV/EBIT reflect meaningful economic realities specific to the industry.

Similarly, a lender should be judged against other lenders. An asset-light company should be assessed through measures that recognise the durability of earnings rather than merely the assets recorded on the balance sheet.

Adding this industry context does not require day-to-day discretion. In a 100% rule-based investment philosophy, the judgement must be built into the rules' design. The framework must decide how companies are grouped, which parameters apply to each group and which weak businesses should be excluded. After that, the process follows the rules.

That is the difference between discipline and false precision. A crude screen also uses rules; however, the question is whether the rules understand what they are measuring.

Therefore, a sound value process begins by identifying the type of business.

For asset-light businesses, such as IT or platform-led companies, book value may not say enough. Earnings durability, return ratios, dividend yield and growth characteristics may provide a better reading of value.

For capital-intensive businesses, such as metals or cement, simple equity multiples can be distorted by debt and depreciation. EV/EBIT or free cash flow-to-enterprise value can provide a cleaner basis for comparison.

For lenders, book value and asset quality become central. Applying industrial-company metrics to finance companies can produce neat answers to the wrong question.

The aim is not to multiply ratios. The aim is to avoid using a ruler where a weighing scale is needed.

How NJ Value Score approaches the problem

NJ Mutual Fund’s Value Score framework is built around the problem of comparability.

The process begins with fundamentally strong companies. These companies are then classified into business-model groups. The classification looks at how the business earns, how capital is used and how sensitive the company may be to economic cycles.

Relevant valuation parameters are then applied within those groups. A capital-intensive company is not judged through the same lens as an asset-light one. A lender is treated as a lender.

The output is a single value score, but the score is not a blunt market-wide ranking. It is built from parameters suited to the business being assessed.

This is rule-based investing in a more demanding sense. The model does not simply sort by cheapness. It first defines what cheapness should mean.

In fact, we did some research and compared two approaches over the period from September 30, 2006, to March 31, 2026.

One approach used NJ’s business-specific Value Score and selected the top 100 stocks by this measure. The other selected the 100-lowest P/E stocks across the market. The Value Score approach showed a higher annualised return, lower annualised volatility, a better Sharpe ratio, a smaller maximum drawdown and a lower five-year loss probability. Its median rolling returns were also better across one-, three-, five-, and ten-year periods.

The right yardstick strengthens the value signal

In the back-test, the business-specific NJ Value Score delivered a stronger return profile than a simple low-P/E screen.

Source: NSE, CMIE, NJ Asset Management Private Limited Internal Research, NJ’s Smart Beta Platform (in-house proprietary model of NJAMC). Data for the period September 30, 2006 to March 31, 2026. Companies with negative earnings are not considered. Value Score Top 100 Stocks represents top 100 stocks based on NJ's Proprietary Business Specific Value Scoring Framework. This data represents a back-tested simulation and does not represent the performance of any existing mutual fund scheme managed by NJ Asset Management Private Limited. Past performance may or may not be sustained in future and is not an indication of future return.

Please note that this evidence should be read carefully. The analysis is back-tested. It does not represent the performance of any existing mutual fund scheme. Past performance may or may not be sustained in future.

Nonetheless, the narrower inference is still useful. A business-specific value framework has historically produced a better signal than a simple low-P/E screen. That is what one would expect when the first method compares similar businesses and the second does not.

Cheapness can still be costly

The gravest error in value investing is mistaking a falling multiple for more value.

A stock may look cheaper because the market has become too pessimistic. But it may also look cheaper because the business is deteriorating. The second case is better known as a value trap.

The warning signs of a value trap usually do not arrive all at once. Profitability may weaken while debt remains high. A dividend may look attractive until cash generation comes under pressure. The valuation multiple may contract and make the stock appear more compelling precisely when the business case is worsening.

This is why cheapness cannot be the final test.

NJ’s framework uses quality and volatility filters alongside the business-specific Value Score. These filters are intended to reduce exposure to companies where low valuation reflects business damage rather than mispricing.

In our research, we found that adding quality and volatility filters to the Value Score portfolio improved the annualised return, Sharpe ratio and maximum drawdown when compared with the unfiltered Value Score portfolio. The filtered version also showed higher, longer-period rolling returns.

Filtering improves an industry-aware value portfolio

Adding quality and volatility filters raised annualised returns while reducing volatility in the back-tested Value Score portfolio.

Source: NSE, CMIE, NJ Asset Management Private Limited Internal Research, NJ’s Smart Beta Platform (in-house proprietary model of NJAMC). Data for the period September 30, 2006 to March 31, 2026. Top 100 stocks by Value Score after Quality & Volatility Filters are based on NJ's Proprietary Business Specific Value Scoring Framework, after filtering low quality and high volatile stocks from Nifty 500. Top 100 stocks by Value Score are based on only NJ's Proprietary Business Specific Value Scoring Framework. This data represents a back-tested simulation and does not represent the performance of any existing mutual fund scheme managed by NJ Asset Management Private Limited. Past performance may or may not be sustained in future and is not an indication of future return.

The improvement is best read as error reduction. That’s because a value process should not only look for discounts, but it should also avoid paying for businesses that deserve a discount.

Value remains cyclical

A better valuation framework does not remove the cycle from value investing.

Value can underperform for long periods. It can suffer when markets favour expensive growth. It can also fall sharply during crises because many value opportunities sit in economically sensitive industries.

A rule-based process cannot change the nature of the value factor. Its task is more limited. It must keep comparisons consistent when markets are noisy and reduce avoidable errors when cheapness becomes tempting.

Many investment mistakes begin with too much faith in one number. A low valuation multiple is useful evidence but it is by no means a verdict.

Conclusion

So, to sum it up: should value be assessed across all stocks or within industry groups?

Well, the full market can be the opportunity set, but the comparison should be made within economically similar groups.

A market-wide low-P/E screen may produce a list of cheap stocks. It may also mix lenders, software companies, commodity producers and utilities into a ranking that says more about accounting structure than undervaluation.

To make the comparison more honest, you need to incorporate industry context. In a rule-based investment process, that means you always get to ask and answer a basic question before any stock is selected: what kind of business is being valued?

And that is an important part of the process because it is the first defence against bad value investing.

FAQs

Q) What is value investing?
Value investing, which seeks to identify and invest in stocks trading below their assessed intrinsic worth, fundamentally focuses on the relationship between a company's market price and its underlying business value. This approach requires investors to exercise patience, as it often takes time for the market to recognise and reflect the true value of undervalued securities.

Q) Should value investing compare all stocks together?
The full market can be used as the investment universe, but valuation comparisons are more meaningful within similar business or industry groups. A single valuation metric across all stocks can mislead because businesses differ in capital intensity, accounting structure and earnings behaviour.

Q) Why can a low P/E stock be risky?
A low P/E stock may be genuinely undervalued. Or it may also reflect peak cyclical earnings or weakening fundamentals. If profits fall later, the stock may prove expensive despite having looked cheap earlier.

Q) Which valuation metrics suit capital-intensive businesses?
Capital-intensive businesses, such as metals or cement, are often better assessed using EV/EBIT and free cash flow-to-enterprise value. These measures can better account for debt, depreciation and capital requirements.

Q) What is the NJ Value Score?
NJ Value Score is NJ Mutual Fund’s rule-based framework for assessing value using business-specific parameters. Companies are classified by business model and evaluated using valuation metrics suited to that group. The aim is to compare similar businesses and identify undervalued, high-quality companies.

Q) Why are quality filters important in value investing?
Quality filters help reduce exposure to value traps. A stock may look cheap because the market has mispriced it. It may also look cheap because the business is deteriorating. Quality filters help separate these cases more effectively.

Q) Can value investing underperform?
Yes. Value investing can underperform for extended periods, especially when markets favour high-growth or speculative stocks. Investors should understand this cyclicality before investing.

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