revisiting (again) value investing

As regular readers will know, I’m a growth stock investor.  That’s even though I spent my first six years as an analyst/portfolio manager using value techniques almost exclusively–and then worked side by side with a motley crew of value investors for a ten-year period after that.

One way of describing the difference between growth and value is that:

–growth investors know when potentially price-moving news will happen (that is, when quarterly earnings are announced) but are less sure what that news will be

–value investors know what the news will be (if they’ve done their job right, they’re holding stocks where the market has already priced in every possible thing that could go wrong.  All they need is one thing to go right).  However, they may have little idea when good news will occur.

 

Each style has an inherent problem:

–for growth, it’s hard to find rising earnings during an economic downturn

–for value, it’s possible that a long time (say, two years) may pass before any of a portfolio’s diamonds in the rough are discovered by the market.  In that case, the manager will likely be fired before the portfolio pays off.  His/her successor will either reap the rewards of the predecessor or will dismantle the portfolio before any good stuff can occur.

 

At times, I do buy what I conceive of a value stocks.  Intel when it was $19, trading at 8x – 9x earnings and yielding almost 4% (I’ve since sold most of what I own) is an example.  But deep value investors would scoff at the notion that this is truly value.

 

For some time, I’ve been maintaining that value investing has lost its appeal in the 21th century.  Two reasons:

–the stronger one is that the shelf life of physical plant, traditional distribution networks and brand names is no longer “forever” in a globalized, Internet-driven world.  So buying companies that are rich in such assets but not making money is much, much riskier today than it used to be.  Such assets can erode in the twinkling of an eye.

–a weaker claim would be that while there are still value names, it’s hard/impossible to fill out a portfolio of, say, 100 of them, which is the traditional value portfolio structure, in today’s world.

 

I’m rehashing the growth/value debate here because I’m thinking the stronger position isn’t as unassailable as I’ve believed.

More tomorrow.

 

momentum investing

what it is

Momentum investing is a style, if one can call it that, of buying and selling securities based simply/solely on recent price momentum.  If a given stock is going up, buy some.  If it continues to rise, buy more.  If a stock begins to decline, sell it   …or, for very aggressive players, sell it short.  No fundamental data counts.

Day traders and very short-term-oriented algorithmic players are the main people who use this simple buy-if-they’re-going -up, sell-if-they’re-going-down rule.  In my career, I’m only aware of two “professional” investment groups who have practiced momentum investing as their main strategy:  Wood Mackenzie trading oil stocks in the early 1980s, Janus trading tech stocks in the late 1990s.  The former was an almost immediate disaster; the latter had a surprisingly long period of success before going down in spectacular flames.

recent use

The term has come into recent vogue in the financial press as a description of growth investing.

It isn’t one, although it may reflect the jaundiced view a few (narrow-minded, in my view) value investors have of their growth colleagues.

To be clear, growth investors try to make money by finding companies that are expanding faster than the consensus expects.  This is not momentum investing.  Nor is the style of value investing that requires that a company not only be bargain-basement cheap but that there be a catalyst (reflected in positive price momentum) for change before buying.

why write about this?

A few days ago, a regular reader, Small Ivy, characterized my speculative dabbling in Tesla as momentum investing.  Maybe so, maybe not.  More tomorrow.

 

value investing and mergers/acquisitions

buy vs. build

When any company is figuring out how it should grow its existing businesses and potentially expand into other areas, it faces the classic “buy or build” problem.  That is to say, it has to decide whether it’s more profitable to use its money to create the new enterprise from the ground up, or whether it’s better to acquire a complementary firm that already has the intellectual property and market presence that our company covets.

There are pluses and minuses to either approach. Build-your-own takes more time.  The  buy-it route is faster, but invariably involves purchasing a firm that’s only available because it has been consigned to the stock market bargain basement because of perceived operational flaws.  Sometimes, acquirers learn to their sorrow that the target they have just bought is like a movie set, something that looks ok from the outside but is only a veneer.

when the urge is greatest

Companies feel the buy/build expansion urge the most keenly at times like today, when they are flush with cash after years of rising profits.

so why isn’t value doing better?

Many economists are explaining the apparent current lack of capital spending by companies by arguing that firms are opting in very large numbers to buy rather than to build.

The beneficiaries of such a universal impulse should be value investors, who specialize in holding slightly broken companies that are trading at large discounts to (what value investors hope is) their intrinsic value.  Growth investors, on the other hand, typically hold the strong-growing companies with high PE stocks who do the acquiring.

On the announcement of a bid, the target company typically goes up.  The bidder’s stock, on the other hand, usually goes down.  That’s partly because the bid is a surprise, partly because the target is perceived to be priced too high, partly simply because of arbitrage activity.

All this leads up to my point.

Over the past couple of years, growth investing has done very well.  Value has lagged badly.  How can this be if merger/acquisition activity continues to be large enough that it is making a significant dent in global capital spending?

 

 

a saturated market

market

Let’s say that a market is the total of all actual and potential customers for a product or service.

saturation

saturated market is one where virtually every potential customer has been turned into an actual one.  At that point, sales gains for a given company can only come from:

–the (slow) growth of the population,

–replacement demand (which can be stimulated by the creation of new versions),

–the sale of maintenance or accessories, or

–taking market share away from competitors.

effect on sales and profits

As a company’s products approach market saturation, sales growth typically slows.  In the terminal phase, expanding as fast as nominal GDP becomes an aspirational goal.  The competitive environment also changes dramatically in a saturated market.  Sales become more costly to obtain, since rivals’ marketing efforts no longer simply expand the market for everyone, but become specifically targeted at taking sales from competitors instead.  This forces every market entrant to spend even more money to defend its present customers.

effect on the stock price

For a growth stock, which is most often trading at an overinflated price earnings multiple as this growth downshift is occurring, the increasing saturation of key markets is especially problematic.  It typically starts to weigh on the PE long before actual saturation occurs.  ESPN, the largest source of earnings for Disney (DIS), and Apple (AAPL) are current examples.

examples

AAPL

The AAPL case is straightforward.  The global market for $600 cellphones is almost completely saturated.  The main demographic cohort in the US that still uses flip-phones is the over 60 (over 70?) crowd.  Technically speaking, one might argue there’s still room to grow.   But for every consumer-oriented technological innovation in my career, this group has been especially resistant to change and tough to crack.  AAPL has never gotten much traction in Europe.  There’s lots of domestic competition in greater China.  The result of worries about an end to growth is the principal reason AAPL shares trade at a sub-market multiple.

DIS

Several years ago, ESPN attempted to expand abroad–a clear signal that it regarded the US market for sports entertainment broadcasting to be saturated.  It was unsuccessful.  Since then, as I see it, DIS has been redirecting cash flow from ESPN to expand its parks and movies businesses.  To my mind, this is the sensible course of action for it.  For a one-product company, which many growth companies tend to be, this is not an option.

 

Tomorrow:  saturation in the e-commerce market in China

value investing today

S&P’s Indexology blog posted an article yesterday on value investing in the US, titled “Losing My Religion.”

The gist of the post is that both over the past one- and ten-year periods, value investing strategies have generally, and pretty steadily, underperformed the S&P.  The author, Tim Edwards, senior director of index investment strategy for S&P, suggests that this may be because value investing has become too popular.  In his words, “With so much energy directed to exploiting the excess returns available through value investing, maybe the only “value” stocks left are the value traps, those stocks whose prices are low as their prospects are determinedly poor.”

my semi-random thoughts

  1.  Value investing has been around at least since the 1930s and is the dominant investment style for professionals worldwide.  Growth stock investing may be a close second to value in the US but is a non-starter elsewhere.
  2. Value investing does not mean buying stocks that are cheap relative to their future prospects, i.e., bargains.  Rather, it’s a rule-governed process of buying, depending on the flavor of value an adherent espouses, the stocks with the lowest price to earnings, price to cash flow or price to net assets ratio–on the idea that the market has already factored into prices the worst that can possible happen, and then some.  So once the market begins to turn an objective eye toward such stocks once more, their prices will rise.  At the same time, downside is limited because the stocks can’t fall off the floor.
  3. As a dyed-in-the-wool growth stock investor (who has worked side by side with value colleagues for virtually all of his professional career),  my observation is that value stock indices routinely include growth stocks.  Growth indices, in contrast, are often salted with stocks that are well past their best-by date and that are ticking time bombs no self-respecting growth stock investor would own.  Academics use these mischaracterized indices to “prove” the superiority of value over growth.  Indexers use similar methodologies.  Be that as it may, this is another reason for surprise at the years-long underperformance of value.
  4. Early in my career I became acquainted with a married couple, where the husband was an excellent growth stock investor, the wife a similarly accomplished value stock picker.  She outperformed him in the first two years of a business cycle; he outperformed her in the next two years.  Their long-term records were identical.  This is how value and growth worked until the late 1990s.

The late 1990s produced a super-long growth cycle that culminated in the Internet bust of 2000.  That was followed by a super value cycle that            ran most of the next 4-5 years.  Both were a break with past patterns.  The strength of the second may be a reason value has looked so bad since.

5.  Still, what I find surprising about the past decade is the persistent underperformance of value, despite the birth of a post-Great Recession                    business cycle in 2009.  The cycle turn has always been the prime period of value outperformance.  Why not now?     …the Internet.

 

More tomorrow.

 

 

comparing growth and value styles

 

Growth                                                        Value

stock volatility high                                   low

character aggressive                                   defensive

upside high                                                    limited

downside can be high                                 low

firms have very bright future                  cheap assets

outperforms bull market                         bear market

benefit from market greed                      market fear

(sell high)                                                       (buy low)

uncertainty extent of rise                        timing of rise

portfolio size 50 issues                            100

 

All this is leading up to talking about why buying is the crucial step for value investors, selling the most important for their growth counterparts.