Value Investing: Not As Easy As it Appears

Value investing presents some of the more interesting challenges in the investing world.  Many individual and institutional investors alike classify themselves as value investors or aspire to adhere to value principals, but often fall short.  Like anything else in the investment world, there isn't an absolute, clear-cut definition of value investing.  Generally, value investing at its core is about buying companies at a discount to their intrinsic value.  This is a broad statement.  In practice, the value investor can approach the process from several different angles.  To each his or her own.  Depending on personal style, or the analytical tools at his or her disposal, the investor may incorporate one or all of the following in analysis.  

1. Use a model based approach, such as a discounted cash flow model, to ascertain a company's intrinsic value.  If the model generated intrinsic value number or stock price number is below market price, buy.
2. Use a multiples-based approach.  Look for companies that are trading at a significant discount to market when using one or a combination of multiples such as price to earnings ratios, price to book, price or enterprise value to ebitda, etc.  
3. Incorporate qualitative analysis techniques to determine whether or not a business has a "sustainable advantage," for instance.  

This seems apparent enough.  Who could argue with buying a stock that is trading below its true value?  At some point, it's got to revert to mean, right??  Returns confirm what seems to be an obvious view.  Historically, global value investing has outperformed the index over time.  The MSCI World Value Index, which according to MSCI uses "eight historical and forward-looking fundamental data points" to determine whether a stock falls in the 50% of the MSCI World index allocated to value or the 50% allocated to growth, has outperformed the headline MSCI World index by approximately a half a percent per year since 1974.  The MSCI World Growth Index has underperformed by about half a percent per annum.  These numbers are based on "simple" returns, i.e. no dividends, because the dividends aren't calculated in my machine all the way back to 1974.  If dividends could be included in the MSCI indices, I'll theorize that the difference in performance between Value and Growth would be wider in favor of Value.  

In practice, though, value investing isn't nearly as neat and simple as it seems for a few reasons.  

First, value returns, whether you're talking about an individual security or the broader value sector can be inconsistent.  Surely, the other side of this coin is the fact that growth is lumpy too.  However, value investing carries an extra set of baggage from an investor perception standpoint.  Investors tend to ascribe certain qualities to value investing, such as "safety," or "consistency" when in reality value investing can't necessarily live up to those ideals all the time.  The connection is clear.  Because value investing involves buying securities trading below "intrinsic value," the phrase "margin of safety" has become an oft used phrase to describe the difference between "intrinsic value" and actual value.  Hence, value investing has become "margin of safety" investing in many investors' minds.  If growth funds or stocks underperform for a spell, it seems to be written off more flippantly than if value underperforms for a certain period.  Lets move to the numbers.  Looking at five year increments from 1974 to the present, we see the following returns:

• 1974 to 1979:  MSCI World +10.869% per annum; World Value +12.7767%.
• 1979 to 1984:  MSCI World +7.377% per annum; World Value +8.0907%.
• 1984 to 1989:  MSCI World +24.841% per annum; World Value +25.988%
• 1989 to 1994:  MSCI World +1.743% per annum; World Value +2.414%
• 1994 to 1999:  MSCI World +18.073% per annum; World Value +14.563%
• 1999 to 2004:  MSCI World -3.818% per annum; World Value +0.425%
• 2004 to 2009:  MSCI World -0.015% per annum; World Value -1.270%
• 2009 to Present:  MSCI World 3.451% per annum; World Value 1.218%

Eight periods are represented above (the 8th isn't quite a full five year period, obviously, but we'll throw it in anyway).  During five, value took the prize.  During three, the Index (and by implication growth) took the prize.  Per annum deviations within these periods can be quite large.  This goes for the current period.  These types of deviations from the norm can certainly try investors' collective patience to a significant degree.  Take the internet boom era from 1994 to 1999, the last gasp of the 18-year secular bull market.  For value investors, it was probably quite frustrating trailing the broader index by several percentage points per year over a five year period.  Without a doubt, it was probably pretty frustrating as well for value managers to have to wake up every month and preach patience to investors watching benefits accrue to the growth folks!  Many value managers watched assets walk out the door in late 1999 and early 2000.  On to the next point...

A second bump in the road, and one that focuses on individual securities, is the fact that just because a stock is trading significantly below intrinsic value doesn't mean it can't fall even further or experience significant volatility.  By their very nature, value names often have "hairy" stories.  Value stocks are usually cheap for a reason.  It's a lot more fun buying growth names with positive news galore.  We'd love to say that it's easy to find companies growing at a super fast clip trading at single-digit multiples, and it can sometimes happen that way due to short-term news flow, but more often than not deep dish value names have a negative story behind them.  Sometimes its stock specific.  Maybe management is bum, or there was fraud, or there was a terrible product launch for instance.  Sometimes it's secular in nature.  Technology has been eclipsed in a certain sector or low commodity prices are affecting a group of commodity producers.  Whatever the case, a lot of patience is required of the value investor.  It'd be great if every stock went up immediately after purchase.  More often than not, it takes waiting and enduring volatility as headlines come and go, many of them ugly.  With information coming fast and furious these days, it's very hard to ignore near-term negative news or negative opinions about a value stock in a portfolio.  Emotion is obviously important, and many value investors have to fight very big lumps in the throat sometimes to hold very cheap stocks facing a barrage of bad publicity.  From an institutional standpoint, the value manager often finds himself or herself answering questions such as, "Why on earth would you ever have that name in the portfolio!?"  Intestinal fortitude is required and, yes, there are times when an investment never recovers from the depths or continues a fall into oblivion.  Two phrases come to mind.  "What Wall St. knows ain't worth knowing."  "Buy when there's blood in the streets."  Sounds simple on paper, but a lot harder in practice.  Time and time again, however, dem' bums catch a positive break, a catalyst that helps take multiples back to a more normal posture.  Momentum is powerful too, in these cases, and sometimes you'll see a stock go from wildly undervalued to wildly overvalued in relatively short-order.  

Finally, and this point is associated with the point directly above about buying out of favor names, it's very important not to get stuck in the weeds looking all the time for the next headline superstar like Apple.  If a company has a solid balance sheet for instance and a high degree of what I'll call "survivability,"  it still has the opportunity to be a standout performer over time, even if it doesn't become the best company in the whole wide world, especially in cases where a company is trading at a very deep discount to the overall market and its peers.  Not every company in every sector can be the "best" at what it does at all times.  The "best" are often ascribed higher than median multiples.  The herd mentality prevails, for a while at least.  Somewhere down the road, though, it's possible and often the case that the "best" stumble somewhere along the way; many of the value cast-aways become the big guys on campus over time.  Let's finish with the Apple example again.  Apple can do no wrong now, but in the late 1990s Dell was on top of the world.  Michael Dell famously said that Apple should cease operations and give the cash back to shareholders.  Apple was cheap.  Consensus stated they deserved the valuation.  Apple's viability was questioned daily.  Apple bashers were quite smug.  Yes, Steve Jobs has been proven a genius but nobody in a million years back then thought that he'd be able to take Apple anywhere but niche status.  Besides, he'd already been unceremoniously dumped from his own company once.  Fast forward a decade or so.  Dell is in the doghouse and Apple is the most valuable company in the world.  Positive headlines about Dell are few and far between.  Apple can do no wrong.  Perhaps another value story and reversal of fortune in the making?

Market Insight - 9-18-2012

Recent central banking events have created quite a lot for for all investors to think about.  Tie in a series of seemingly never-ending economic and geopolitical calamities and things get murkier still. In one camp, many long term value investors are pointing to five and ten year normalized P/E ratios and indicating that the return environment, mainly in the US, looks ugly over the next ten years.  In another camp, which we'll term the "Don't Fight the Fed" contingent, Benanke's open ended support statement combined with Monti's aggressiveness means that all of our economic and political worries can be pushed to the side; ample liquidity should keep a solid bid under risk assets such as equities.  Is this an either/or situation?  It's always tricky comparing one equity market environment to another, but there is a situation that bears some resemblance to the current situation: 1997/1998.  If we'd lined up the same debate teams at the outset of 1998 and reviewed the situation a decade later, both sides could have declared a victory.  It all depends on timeframe.  Importantly, the series of market events in 1998, and the subsequent action over the following ten years, shows that market analysis, often boiled down to simple straight line statistical constructs, is far from a straight line game.

Looking back briefly, the global economies in 1997 and 1998 were marked by significant macro turmoil.  In late 1997, the Asian currency crisis started, and the turmoil spread throughout the world over the course of 1998.  Latin American countries such as Brazil and Mexico faced stresses.  During the summer of 1998, the Russian debt crisis exploded.  The IMF was putting out fires everywhere.  Missiles were fired at suspected Al Qaeda camps in Afghanistan in August.  Over the entire period, the US body politic was consumed and paralyzed by the Clinton/Lewinsky affair.  Adding insult to injury, a highly leveraged hedge fund, Long Term Capital Management, nearly blew up amid the turmoil in September and brought Wall St. to its collective knees.  Decisive Fed intervention in the LTCM case prevented a much larger market structure calamity.  Going into the summer of 1998, valuations in US markets, for instance, were already significantly stretched, with both 5 and 10 year normalized P/E ratios above 30x.  With a terrible macro backdrop, if there were anytime for a major secular bear market to begin, it certainly could've been then.  At the valuations seen in June 1998, normalized P/E ratios predicted future 10 year real total returns of around -1% per annum.  Fed Chairman Alan Greenspan had delivered a speech two years prior discussing the "irrational exuberance" in the marketplace.  Looking forward, Y2K loomed on the horizon.  Amidst the turmoil, the S&P 500 in the US declined approximately 22% peak to trough from July 1998 to October 1998.  The MSCI World declined approximately 20% peak to trough.  Global markets looked very similar to what we just witnessed in the fall of 2011.  In response, during the fall of 1998, the Federal Reserve lowered the target Fed Funds rate by a a whopping full percentage point sending risk assets around the world off to the races.  The Fed used other mechanisms as well to inject liquidity into the economy ahead of Y2K, helping broader market sentiment.  Market participants were able to ignore geopolitical concerns and focus solely on the internet and technology boom.  From fall 1998 to the spring of 2000, the S&P 500 rallied approximately 50%, providing much gloating among the new internet valuation paradigm and Don't Fight the Fed crowds.  Value investors around the world lagged significantly, with some famous value investors even retiring in 1999.

That's only part of the history, of course.  That last gasp into spring 2000 proved to be the end of the 18 year secular bull market.  Markets declined dramatically from 2000 to late 2002, and market have remained relatively stuck in the mud from 2000 to 2012.

Again, revisiting the "who won" argument, one can demonstrate that both camps could have "won" in 1998.  Despite valuations never before seen, the market was able to rally by 50% in approximately a year and a half making short-term fools of the value camp.  Being short in 1999 on the basis of valuation was a heartburn-inducing strategy to put it mildly.  Looking forward 10-years, however, from the summer of 1998, normalized P/E ratios and general valuation proved to be a reliable forward predictor.  Between the summer of 1998 and the summer of 2008, total real annualized returns for the S&P came in at around 0% to negative 1% per annum depending on which month you choose as your starting point, very close to to the predicted values.  Over the longer-term, the value camp proved prescient.

Fast forward to today.  We've dealt with the European Debt Crisis, China Concerns, debt rating cuts, muddle through economies, you name it.  The dreaded fiscal cliff sits on the horizon, not to mention a contentious Presidential election, future uncertainty in Europe, and future uncertainty in emerging markets.  Normalized valuations, though not as stretched as 1998, remain well above historical average with 5-year normalized P/E at 23.5x and the 10 year normalized P/E at 22.3x.  Normalized P/Es predict that that future 10 year real total returns in the US will come in at around 2% to 3% per annum, unimpressive by historical standards.  Global developed markets look better, but with the recent rallies valuations are average at best.  Yet, in the face of macro concerns and valuation concerns, US markets are close to market new all time highs (in nominal terms).  The S&P is now up approximately 36% from the intra-day lows set last fall.  The Don't Fight the Central Banks armada is out in full force and markets have maintained a healthy posture, even on down days.  Value Cassandras continue to put out their valuation warnings.  Like 1998, both could be right again.  It wouldn't be a surprise in the least to see risk markets maintain their upward trajectory and to see multiples expand in the US and around the world over the next several months (or even couple of years).  By the same token, current long-term valuations point to a market that should remain choppy, frustrating, and underwhelming from a performance perspective over the next 10 years.

What are the morals of the story?  First, timeframe is incredibly important when dealing with expectations.  Explaining a market view can be extremely complicated.  One can be bullish in the short-term but cautious about the long-term, for instance.  Having a process that takes multiple timeframes into account matters.  Second, long-term valuation indicators are not very good at predicting short-term cyclical moves, but have a darn good record in predicting long-term returns.  This seems obvious, but gets lost in the weeds.  Third, for long-term value investors, patience and intestinal fortitude are often required to make it intact through a treacherous investment journey.  At overvalued points like 1998 or the current timeframe, value investors are often maligned as being out of touch while markets march higher and higher and fear recedes into the background.  Over ensuing years however, the patience usually leads to opportunities to buy assets at better prices.  Of course, when better prices arrive at a future date, many people think you're crazy for touching risk assets.