Value Investing Is Dead. Long Live Value Investing.
During the Financial Crisis, an innovative website created the hedge fund “implode-o-meter” to track the number of funds that went “tits up” in the extreme market conditions. The collapse of the housing sector and credit crunch taught hedge fund managers of the dangerous double-edged sword that comes with excessive leverage. Some 117 hedge funds went out of business during and in the wake of the Financial
Fast-forward to 2018. Financial stocks, the “Value stocks” par excellence, have lagged throughout the tenyear bull market. This is not surprising, as a quick read of our August 25, 2017 Commentary, “Looking Into Our Crystal Ball” will demonstrate. We asserted that:
“The asset class being the source/cause of a financial “mania” in the current cycle will fall relatively more than other asset classes at the end of the cycle AND become a notable laggard in the subsequent cycle”.
Another large sector constituting “value stocks”, Energy has also had a rough bull market relative to the broad market equity rally. The Energy SPDR (XLE) fell -45% between 2014 and 2016, even as the S&P 500 barely dipped. Lacking the relative strength of Financial and Energy company stocks, the Value indexes have lagged their equivalent growth homologues.
Knowing that Value managers have been essentially in Finance and Energy names during this bull market (and certainly not holding the FANG stocks) it will not surprise readers to know that Value funds have been under-performing. Moreover, Value managers have either (1) seen such large outflows that they have closed their funds (sort of like hedge funds in 2008-09) or (2) re-invented themselves by “expanding” their Value universe, succumbing to “style drift” (ie: becoming Growth managers themselves).
It has undisputedly been a rough stretch for Value stocks, as defined by Standard & Poor’s and the FTSE Russell Company. To recall, S&P and Russell generally include in their Growth indexes companies with above-average risk-adjusted rates of return and high retention rates (that is, pay little or no dividends). Conversely, Companies in the Value indexes are undervalued for reasons besides earnings growth potential. Value companies typically have low P/E and P/BV ratios and pay higher dividends. As shown in the following chart, the Value theme dominated from the peak of the Tech Bubble until the start of the Financial Crisis – a period of seven years.
Growth stocks have now dominated for eleven years. Based on the S&P Growth and Value Indexes, the relative performance line is heading for a “round-tripper” (Growth stocks will soon recover all their losses, on a relative basis, since the Tech Bubble peak.
After eleven years, investors have become ingrained with the Clintonesque expression, “it’s Growth, stupid”. Value is dead. Technology companies are the Second Coming. The problem with these assertions, as any student of market history will point out, is that “Trees do not grow to the sky and their roots do not descend to Hell”. And, after an eleven year relative up-trend, the big question is at what point will have all investors crowded into Tech and Growth stocks?
As readers can guess from our satirical title, we don’t believe that Value is dead. Moreover, given the widening spread between Growth stock valuations and Value stocks valuations, we would guess that the eleven-year relative out-performance of Growth/Value is very late in the game. An economic recession will hit the U.S. sometime in the future (the Federal Reserve ultra-accommodative monetary policy is NOT the miraculous cure for the economic cycle). And with the current economic expansion at 106 months and counting, this expansion will eventually die of old age (if not a Fed policy error). Recall that the record length of an expansion was 120 months (1991-2001). The proximity of the next recession is important for the dynamic between Growth and Value. With the exception of the 2007-2009 recession and the collapse of bank stocks (defined traditionally as “Value” stocks), it is Value that tends to outperform from the last stage of an economic expansion.
It would appear that the next economic recession is not yet upon us. Two market indicators support this assertion. First, the relative out-performance of Growth has shown no signs of slowing. Second, as evoked in our April 20 Commentary, “Yields Will Signal The End of The Bull Market”, the 10-Year/2-Year U.S. Treasury yield curve has yet to invert. An inversion of the yield curve has preceded prior stock market tops, which in turn has preceded the beginning of recessions. Some argue that central bank manipulation of the short-end of the yield curve has rendered obsolete this tried and true omen of an upcoming recession. This may very well be true, but at this stage of the game, the broken yield curve hypothesis remains speculation.
Unlike Standard & Poor’s or Russell, who more or less classify Financials, Energy, Telecom and Pharmaceutical companies in their Value indexes and Technology (with a spattering of Industrials and Consumer Discretionary) companies in their Growth indexes, the WMA fundamental ranking system may rank any type of company as “Value”. To arrive at our short-list of Value companies, we look at several fundamental criteria:
- Valuation score, composed of a composite in-house ranking of companies according to their current enterprise value relative to forecasted EBITDA as well as the current enterprise value relative to forecasted sales. For Financial firms, we use a proxy for enterprise value that includes the WACC Total Capital of the bank.
- PER score, composed of the consensus forecasted Price/Earnings ratio for the current year and the forecasted Price/Earnings ratio for next year.
- Book Value score, composed the Price/Book Value Ratio for each firm. We relax this criterion for Tech companies whose market value includes often valuable Intellectual Property and for certain firms, such as Railroads, carrying valuable assets (like land) at acquisition cost.
Within our Top Picks Strategy, we invest one-third of the portfolio in Value companies. A second level of fundamental screening considers our score for Profitability, Financial Situation, Earnings/Sales Revisions, Return on Owners’ Equity, and Analyst Consensus Recommendation. The third and final screen involves a technical analysis of the stock price’s intermediate trend plus the relative strength trend of the company stock versus the benchmark index (U.S. Total Market Index). Stocks that are in both intermediate absolute and relative downtrends are disqualified as Value stocks in our methodology.
We believe that most of the Street is so disgusted with value after so many years of underperformance (Value Is Dead) that we are likely nearing a generational buying point for Value (much as the Financial Crisis offered a generational buying opportunity for Growth investors). Bill and Owen decided to launch a new equity strategy portfolio dedicated to “Deep Value” stocks. The originality of this strategy is that we consider companies of all market caps, all sectors, and all counties that meet our Value criteria:
- Valuation score in the top 85% of our 4000+ stock universe
- PER score in the top 85% of our 4000+ stock universe
- Book Value score (for non-Tech companies) in the top 60% of our 4000+ stock universe
Unlike in Top Picks, the WMA Deep Value portfolio relaxes the price trend criteria. Why? Most often Deep Value stocks have a beaten down market price. We’ll often be buying companies whose stocks are trading below their 40-week moving averages. In this sense, the portfolio is making “return to the mean” bets. Recall that Top Picks is trading Quality companies with a positive price dynamic.
The next obvious question a reader may be asking is how do we avoid “value traps”? To avoid buying companies that risk never returning to the mean (“bouncing”), we add a second level fundamental filter using our Financial Situation score. Value companies must rank highly in categories such as Net Debt / EBIT, Total Debt / Total Equity and Free Cash Flow / Enterprise Value.
As this biggest risk to a Deep Value strategy is buying a company whose price just keeps sinking forever, we add a third fundamental filter. We look at year/year EPS and sales growth rates in addition to 6-month, 3-motnh, and 4-weeks EPS and Sales revisions. We disqualify companies whose 3-month and 4-week revisions are negative if either the annual or semi-annual forecasted growth rates are falling. That is, if we can see near-term improvement in earnings and sales revisions, we’ll take a chance on a company, even if its current annual growth rate is negative.
One company in our Deep Value Portfolio is Celestica (CLS), a small-cap industrial based in Toronto, Canada. Celestica is one of the world’s top electronics manufacturing services companies. Their output is mainly complex printed circuit assemblies, such as PC motherboards and communication networking cards.
Celestica ranks in the top 96% for Valuation, the top 89% for PER, and the top 91% for Book Value. Its Financial Situation does not appear to be concern and sales revisions are positive. We’ll have to hope improved sales trickle down to earnings, as EPS revisions are still negative.
Another company that we chose for our Deep Value strategy is Micron (MU), a large-cap technology company based in Boise, Idaho. Micron Technology is one of the largest memory chip makers in the world. Micron makes DRAM (Dynamic Random Access Memory), NAND Flash, and NOR Flash memory.
Micron ranks in the top 92% for Valuation, the top 100% for PER (again, using analyst consensus forward earnings). While we did not consider Book Value (as MU is a tech company), its P/VB score still puts the company in our top 84%. Its Financial Situation is healthy and sales + EPS revisions are sharply positive.
Update portfolio holdings will be posted on the WMA site under the Portfolios Tab each week.
At this stage of the economic and stock market cycle, we like Value for a buy-and-hold investment. Growth is crowded and valuations are more than stretched at current levels. Only traders should be in Growth companies like Amazon, Google, Facebook whose stock prices have gone parabolic. But the FANGs are indeed still out-performing. Is it too early to rotate into Value stocks? Or do we still need to see more Value managers go out of business before there is blood in the streets? No one has a crystal ball and will be able to predict when this esoteric orgy going on in technology stocks will end. We believe tech will be the last sector to release in this bull market, meaning relative outperformance of growth may continue until the absolute peak of the stock bull market. This does not mean riding the Growth wave at 100% invested until the end (as the end make transpire quickly). Rotating gradually into a value strategy, such as our Deep Value portfolio, makes sense to us at this stage of the cycle.
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