Tag Archives: value investing

how traditional value investing has to change

October 28, 2015 By in book value, distressed assets, from growth to value: the life cycle, growth vs value, mean reversion, Strategy Tags: , , , , Leave a comment

Yesterday I wrote about the Indexology observation that value investing hasn’t worked well over the past decade.  That’s a long time.  Here’s what I think is happening:

Every professional investor, no matter how he describes what he does, looks to buy undervalued securities.  That’s not unique to value investors, no matter how academics may insist otherwise.  Growth stock investors seek this undervaluation in the market’s underestimation of a company’s future prospects, as measured by how fast earnings are growing, how the trajectory is accelerating and how long super-normal growth  may continue.  Value investors look for undervaluation in underestimation of the worth of companies’ here-and-now, based on metrics like price to book, price to cash flow and price to earnings.

 

Most often, value investors are attracted to companies that:

–are suffering from temporary misfortune–the wrong part of the business cycle or a management miscue–that the market mistakenly thinks is a permanent defect, or

–are badly run, but the market doesn’t realize that change is possible, either by action by the board of directors or by third parties forcing change of control.

In either case, the presumption is that cumulative spending on property, physical plant and equipment or on intangibles like brand names, patents, distribution networks or building brand names through advertising and marketing all have an enduring value that will most likely grow with time.  In the worst case, the worth of these assets will erode only very slowly.

 

This assumption is value investing’s chief problem, I think.

How so?

–through e-commerce and social media, the internet continues to erode the value of traditional distribution networks and the power of the decades of advertising and marketing spending that have established and (until a decade or so ago) protected them

—generational change.  The gradual but steady replacement of the Baby Boom by younger generations who want to distinguish themselves from their parents means not only a change in what categories consumers spend on but a change in tastes, implying traditional firms may not benefit

—the Great Recession.  In my experience, big economic downturns most often trigger changes in behavior.  They’re the reason for reassessing and changing spending habits.  They are also, if nothing else, the excuse for severing traditional relationships.  Some of this is economic necessity, some not.  Gen-Xers, for example, congregate in cities instead of the suburbs where their parents live.  They can’t afford to get sick and miss work, and they can’t afford restaurant meals, so they avoid fast food and make healthy meals at home.  They use mass transportation rather than owning a car.  Macys and McDonalds are the last places you’ll find them.

These three developments all attack the traditional order, and thereby undermine the assumption of the relative permanence of asset value for many firms.  This phenomenon is greatest in consumer-facing enterprises, less so in industrial.

 

The result is, I think, that value investors have to become more like their growth colleagues in investigating in great depth a firm’s ability to withstand the disruptive forces I’ve just listed.  Buying and selling based on screens of low price to book, low price to cash flow and low price to earnings is no longer enough

 

value investing today

October 27, 2015 By in Absolute vs. relative performance, book value, growth vs value, mean reversion, Strategy, two flavors of value Tags: , , , , , , 2 Comments

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 rule can involve 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.  If 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.

why buying is the key decision for value investors

June 25, 2015 By in distressed assets, growth vs value, mean reversion, two flavors of value Tags: , , , , , , Leave a comment

Value investors like to describe themselves as buying companies worth $1 for, say, $.20 and selling them for $.80.  Less ambitious practitioners say buying for $.30 and selling for $.70.   But the idea is the same–buy at a deep discount, sell at a slight discount.

What remains unexpressed, but what’s crucial for value investors, is that the firm in question is not being assessed on any pie-in-the-sky future developments, but on an evaluation of what the company as it stands now is worth.

Three types of situations get value investors particularly excited:

–periods of general stock market undervaluation,

–overall business cycle slumps, or specific industry group declines, when the market fears that an (inevitable) upturn won’t happen and decides to unload the underperforming stocks into the market for whatever they can get, or

–companies that are industry laggards and which would fare far better if run by more competent managers.

In a sense, all of these situations involve temporarily damaged goods.

In each case, value investors also have plenty of data for figuring out what normal or reasonable prices for now-undervalued companies should be.  The data might be projections from past industry or economic cycles about how far earnings might rebound during an upcycle and how far price earnings multiples might change (usually expand).  In the case of badly run firms, the comparison is with healthy companies in the same industry.

In every instance, however, it’s a relatively straightforward thing to set a target price–what the company would be worth in better times.

The more difficult question is at what price to buy.

Investors will certainly demand a premium, say, 20% or 30%, for taking the risk of making a purchase while a business may be doing badly or while the overall market is cringing in fear.

Beyond that, value investors seem to me to fall into two types:

–those who are willing to buy at what they consider a rock-bottom price, regardless of the near-term outlook, and

–those who are waiting to see an initial ray of sunshine, or a “catalyst,” that convinces them that the worst is past.

In the first case, the skill is in judging the bottom.  In the second, it’s finding the turn upward before the market in general does.  But in both cases, it’s the decision to buy that’s the key to success.

 

 

 

 

comparing growth and value styles

June 24, 2015 By in book value, distressed assets, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, two flavors of value Tags: , , 1 Comment

 

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.

growth vs. value test: my answers

June 23, 2015 By in book value, cash flow/share vs. earnings/share, from growth to value: the life cycle, growth vs value, mean reversion, return on equity, return on equity vs. return on capital, two flavors of value Tags: , , 2 Comments

The growth stock investor’s answer:  Joe’s, of course.  Why?  I pay $18 for the stock now.  At the end of five years, earnings per share will likely be $2.70.  Assuming the stock keeps the same p/e multiple, its price will be $48 and I will have almost tripled my money.

Look at Bill’s in contrast.  I pay $10 for the stock.  At the end of five years, eps will be up 61% and I will have collected $2.50 in dividends (which I may have to pay tax on, but let’s not count that here).  Assuming the stock keeps the same multiple, it will be trading at $16.10.  Add in the dividends and the total is $18.60.  That’s a return of 86%, or about half what I would get from holding Joe’s.

One more thing.  Maybe in five years, people will start to worry about whether Joe’s can continue to expand at its current rate.  As a result, the p/e multiple could begin to contract.  Maybe that will happen, maybe not.  But even if it does, the multiple will have to drop from 18 to 12! before I would be better off with Bill’s.

The value stock investor’s answer:  It’s obviously Bill’s.  Joe’s has a much more aggressive  growth strategy.  Maybe it will work, maybe not.  I don’t see why I have to decide.  A lot of the potential reward for success is already built into Joe’s current stock price.  And if Joe’s strategy is unsuccessful, the stock has a very long way to fall.

If Joe’s strategy doesn’t work, then I’m much better off with Bill’s.  On the other hand, suppose it really is the way to go.  In that case, either Bill’s management will see the light and adopt a more aggressive stance itself, or the board or activist shareholders or a potential predator (Joe’s?) will force a change.  And the stock will skyrocket.  While it may take a little more time, I’ll enjoy all the rewards of backing the winning strategy without taking on the higher risk of holding Joe’s.

It’s a question of temperament.  A conversation between the growth and value sides could have several more rounds before it degenerated into name-calling, but you have the basic idea already.

Maybe the most salient points to be made about each answer are:

–not that many companies grow so rapidly as Joe’s without any hiccups;

–wresting control from an entrenched management is not that easy (look at the sorry history of  Western-style value investing in Japan–or most places in Continental Europe, for that matter–for confirmation).  It may not be possible, and could be a long and arduous process in any event.