The Value of Value

Much has been said recently about the underperformance of value stocks relative to growth stocks. Historically, over the long term, value stocks—those with lower relative multiples—outperform growth stocks—the high flying, glamourous ones that tend to trade at lofty multiples of earnings, cash flow, sales and book value. The long-term performance of growth stocks lags that of value as the underappreciated lower-valued companies tend to revert to fair value and the overly-enamoured high-growth businesses generally fail to meet elevated expectations and fall to fair value.

Over the last 50 plus years value stocks have significantly outperformed the market. In general, the better the value (i.e., lower multiples) the higher the subsequent returns and this phenomenon is persistent across most countries too. And, over the long term, growth stocks have underperformed the market. But growth has now outperformed value for the last 10 years for a host of reasons.

With slow economic growth and muted inflation, interest rates have remained low which favours stocks in general and higher growth equities specifically, as the present value of expected future cash flows rises given the skew of cash flows to later time frames. Also, in a slower economic environment, which has persisted since the ’08 Great Recession, growth is prized. Furthermore, the last several years have been marked by the domination of a number of burgeoning, disruptive companies like Facebook, Amazon, Apple, Microsoft and Alphabet (Google). The market’s preoccupation with these types of companies has been legitimized by their remarkable business models with significant and surging profitability. Finally, since we are just shy of the longest economic cycle in modern history, investors are dismissing concerns of recession and maintaining elevated animal spirits, regardless of valuations.

Value Matters

While some companies periodically trade above their Fair Market Values (FMVs), most companies achieve FMV and then revert toward being undervalued. Once FMV is reached companies become vulnerable to negative news because at FMV a company’s share price, by definition, will only grow by its implied discount rate. Since most market participants require a higher rate of return to compensate for risk, stocks usually sell off once they achieve fair value. And they do so at a brisker pace when the outlook deteriorates.

So one must calculate FMVs and continually update them to properly anticipate and react to share price fluctations. A study we completed a few years ago and recently updated shows that even the largest companies in the world endure regular selloffs—peak to trough corrections—of about 17% on average, each and every calendar year. Therein lies both risk and opportunity

Undervalued

As a reminder, we don’t buy ‘value’ stocks, we buy undervalued stocks. That may sound like semantics, but we only buy individual positions when they meet our specific criteria, not simply positions that are trading at relatively lower valuation multiples. We look for high quality companies—predictable businesses that ought to remain so from inherent competitive advantages. These businesses typically have consistently rising FMVs. Usually with our purchases, some short-term disappointment has caused uncertainty, and in turn selling pressure, pushing a stock price down to attractive levels. And we aren’t shy about pouncing when we believe we can take advantage of potential market misjudgments which have knocked share prices down to TRAC^TM floors—at attractive levels relative to our FMV estimates, with an expectation of outsized rates of return when they rise back to fair value in relative short order. We spend time analyzing each company so that we are in a position to best arrive at a credible appraisal of each company’s intrinsic value—a necessary reference point for establishing the size of the discount relative to prevailing prices to assist with loss mitigation and return potential as well as for pinpointing when to sell.

While we are always concerned about making more than our fair share of mistakes in our assessment of companies’ prospects or from the impact from adverse unanticipated events, we don’t worry about value investing being out of favour. Picking stocks at discounts to fair values and waiting for other investors to appreciate the underlying businesses is not an investment style per se, rather it’s merely a common sense approach. Ignoring value to us is akin to shopping and offering to pay higher than the labeled prices or ignoring sales signs.

Fully Valued

When we sell a position it is generally for one of a handful of reasons: it’s fully valued and susceptible to decline; it has inflected off a TRAC^TM ceiling or transited through a floor, providing a sell signal and therefore likely to fall further; the fundamentals of the business have faltered altering our opinion of the enterprise; we have discovered another opportunity in a higher-quality stock at a more attractive valuation; or we are concerned about the prospects of a bear market and are looking to decrease our overall exposure to the market.

Overvalued

Individual stocks, sectors and market indexes generally ebb and flow between undervaluation and fair value. Because all stocks don’t move together, the overall market has a more muted movement around its FMV. In a rising economy, stock market corrections may be limited to less than 20%—approximately the magnitude down from a TRAC^TM ceiling to the next floor—because sentiment is generally positive and FMVs, floors and ceilings are rising.

For our long/short accounts, we have not been short selling for several years even though we have found opportunities to short individual overvalued companies because rising markets tend to lift virtually all positions. We prefer to assume short exposure only when our macro tools alert us to potential deterioration in the business cycle and overall market. In such cases our intention would be to do so via shorting ETFs (or buying inverse long ETFs) rather than specific companies. When a recession starts, an erosion of fundamentals can occur quickly resulting in markets being overvalued. Bear markets can bring nasty declines as the market deals with the wicked combination of declining FMVs and negative sentiment, quite often resulting in a fear-based overshoot to the downside. Accordingly, we need to be ready to hedge the impact of a deleterious market.