I made a New Years Resolution to start writing up more companies. (I also would like to eat healthier and use less profanity, but I really enjoy Ben and Jerry’s and there are a lot of bad drivers.)

I want to turn over more rocks in the investment universe and do deeper dives.

This ought to add to my “crash wishlist” of companies which ought to be useful the next time that the market takes a dive. It will make me less reliant on stock screens if I’ve already done the homework.

I set up a Substack to facilitate these efforts.

Every entry in this substack will be a “company analysis” style post that I previously posted on this blog. Previously, I only wrote up companies that I decided to buy. Going forward, I am going to try to do more write up’s, including companies that I pass on.

I hope to analyze a lot of companies that are currently too expensive for my taste, but would be appealing at a more compelling price after a stock market crash, for instance.

I will still continue to update this blog and keep track of my portfolio in real time. I’ll continue to post my thoughts on investing concepts along with book reviews. I’ll continue to provide updates on my portfolio. However, the specific company level analysis will be posted in Substack.

If you would like to get on the mailing list, click here: https://valuestockgeek.substack.com/

Below is a copy of the first post, outlining the goals for the Substack. You can also read it here.

In Search of Wonderful Companies at Wonderful Prices

Greetings!

I have a blog where I track the performance of a real brokerage account where I invest my own money.

In the past, I only wrote about the companies that I decided to buy.

I’m starting this substack to do more company write-up’s. I am even going to write about companies that I don’t buy. I will still maintain my blog to track the performance of my portfolio, but I would like to use this substack as a medium to write up many companies – even ones that I pass on.

I am hunting for wonderful companies at wonderful prices, which I hold in a concentrated 12-15 stock portfolio.

“Wonderful companies at wonderful prices” is an extraordinarily tall order, but I don’t want to settle for anything less than that. I’m running an extremely concentrated portfolio, which means I have some very strict criteria. There are thousands of stocks globally, and I should be able to find 12-15 stocks meeting my criteria to fill up a portfolio.

I will pass on many companies because they don’t meet 100% of my criteria. Many will turn out to be great investments, anyway. I’m alright with that. I don’t need to be right about everything.

The sort of companies that I write up will meet most of my criteria. They have to at least pass a certain hurdle to get my attention to look deeply into it.

Because I am looking for cheap, high-quality businesses, you won’t find me writing up companies that are a cheap-dumpster-fire-with-potential (at one end of the spectrum) or excellent companies that are trading at very expensive prices (at the other).

To get my attention, it has to at least quantitatively look like it meets most of my criteria. This means I’ll write up companies like General Dynamics, but probably not Tesla (at one end of the spectrum) or a money-losing gold miner below tangible book (at the other end of the spectrum).

With all of that said, for every write-up, I will run through my checklist of criteria:

• Can the stock deliver a 10% CAGR for the next decade?I am looking for situations where shareholder yield (dividends + buybacks) combined with modest growth in the business could deliver a 10% CAGR over the next 10 years.I would like the company to generate this shareholder yield with free cash flow that the business creates on its own. I’m not interested in companies that are issuing debt to buy back shares and issue dividends, which is a troubling sign.I do not want to rely on multiple appreciation (i.e., the P/E goes from 5 to 10) for my return. I tried for years to try to make money that way and failed at it. For future purchases, I am looking for businesses that are worthy of being held, not just traded for a pop in the next year.
  
  If I can’t meet this 10% hurdle, then I might as well own my asset allocation strategy, which I wrote about on Medium here.
  
  Owning individual securities is highly risky. Even the excellent situations that I’m looking for will have higher risks than a simple asset allocation strategy. If I can’t meet a 10% return hurdle as compensation for this risk, then I might as well own my asset allocation.
• Has the business delivered consistent results over a long period of time? I am not looking for businesses where they endure a relentless boom-bust cycle. I want something with a proven track record of performance. I want a business that has survived recessions and thrived.
  
  I don’t want to rely on capturing a business at the nadir of a cycle and selling at a top. I will try to capture a business near a nadir – but I want the type of business where even if I get the timing wrong, I can still earn a decent return.
• Does the return on equity consistently exceed 10% without the use of heavy leverage?This ties into my 10% return hurdle. Over the very long run (20+ years), the CAGR on most stocks is closely tied to the business’ return on equity over that time period.I would prefer a lot more than a 10% return on equity, but that’s the bare minimum to meet my return hurdle.
  
  I also don’t want companies that achieve a high ROE with the use of heavy leverage. Leverage works until it doesn’t. Even a rock-solid stable business can encounter unexpected trouble.
• Is management sketchy?I don’t need the management team to be superstars. However, I do not want to be in business with someone who is dishonest or unethical. I don’t want to be in business with someone who can potentially be a fraud or engage in unethical practices that can sink a business. This means avoiding grifters, promoters, or the type of CEO’s that are obsessed with short sellers.
• Is the company financially healthy?I discussed “low leverage” in the return on equity point, but there is more to financial health than low debt.In addition to a low debt/equity ratio, I will also take a look at the following criteria to assess financial health: 1) Interest coverage, 2) Altman Z-Score (bankruptcy risk), 3) M-Score (a measure that looks for signs of earnings manipulation), 4) Returns on capital consistently exceed the cost of capital.
• Has the company consistently generated returns for shareholders? Is the industry in secular decline?I want companies that have already proven that they can generate returns for shareholders. I don’t want to speculate on companies without a proven track record. This means I will mostly avoid new & exciting companies. I’ll also avoid companies that appear to be in secular decline.
• Has the company survived previous recessions? The economic cycle is unpredictable. This is a lesson I learned the hard way because I’ve tried to predict it and failed at it.I operate under the assumption that another 2007-09 recession can happen tomorrow. For that reason, I only want to hold companies that have proven themselves as able to endure past recessions without destroying shareholder value. If something had a 90% drawdown in 2008 and the firm was brought to the brink of bankruptcy, then I don’t want to own it in my portfolio.This criteria is also for my own psychology. I’m a risk-averse, pessimistic individual. When the world is going to hell in a handbasket, I don’t want to panic sell at the bottom. If I hold a business that has the ability to survive, then I can continue to hold it.
• Does the company have a moat?I am looking for businesses with strong defenses against the competition. If a competitor can copy the company’s business model and kill it, then I’m not interested in owning it. If the product is commoditized and a lower price can causes customers to switch, then I’m not interested. I want businesses that have the ability to survive and are worth being held for long periods of time. I’m not interested in fads. I’m interested in businesses that will continue generating excess returns for the next 10 years.
• Is the stock cheap on an absolute and relative basis?I want to pick up bargain securities that trade with a margin of safety.There are two reasons for this: 1) I want multiple appreciations to be a potential source of returns even though I don’t want to rely on it. 2) I don’t want to get killed by multiple compression. Coca-Cola in the late ‘90s was a wonderful business, but the market bid it up to a P/E of 50. It spent the next 10 years delivering zero returns to shareholders even while the underlying business grew.I want the cheapness of the stock to be obvious. I am not trying to find a margin of safety by torturing a DCF until it gives me the answer I want. I want actual quantitative bargains with low multiples.If I can maintain my discipline in this area, then it will keep me out of the hottest stocks and the hottest industries. That is by design.
• If I was forced to hold the stock for 10 years, would I be terrified?This point combines all of the above criteria. I want to own businesses worthy of being held and I want to own them at compelling prices. If the thought of not being able to sell is terrifying, then I probably shouldn’t own it at all.

Future write-up’s will analyze companies on all of these points.

Random

One of my favorite rush songs. I was fortunate enough to hear them play it live back in 2011.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Defining a Wonderful Company

In previous posts, I described the kind of situations that I’m looking for: wonderful companies at wonderful prices.

There are many examples of this phenomenon in markets. Defense companies with outstanding long-term track records were available at compelling deep value multiples in 2011 when the US government briefly pretended that it found fiscal discipline religion.

Apple was available at a 10 P/E in 2013 and 2016.

Domino’s pizza was available at deep value multiples in the early 2010’s. The same is true of Mastercard.

I’ve also provided examples of value investors who identified these opportunities, so you can’t say “Yes, but no one could have predicted that.”

The way I see it, if you can find a company with a wonderful track record and you can buy it at a compelling price – the odds are strong that it will work out.

What’s a wonderful company? It’s a company that has an outstanding track record. Their business is predictable. Margins remain relatively consistent. They have a track record of maintaining high returns on capital without the use of heavy leverage. They have a strong moat and would be difficult to compete with. A few punks with laptops can’t disrupt it. They’ve been through many economic cycles and they’ve survived. It doesn’t take a leap of imagination to envision positive long-term growth prospects (i.e., people will continue to order take out pizza on Friday nights, Mastercard’s volumes will increase as we abandon cash, Apple users like their phone and will replace it every two years, etc.)

I used to think it was hard to identify these companies but I no longer think that’s the case. It doesn’t take a genius to figure out that Coca Cola and Colgate have formidable moats and good businesses, for instance. I also don’t think it’s that hard to see that tire companies, video game retailers, steel companies, and airlines (all of which I’ve invested in) are bad businesses.

A wonderful company is the kind of company that I can put my money into and don’t have to watch the price every day and hold my breath whenever I read a K or Q. I don’t want to have to worry about where we are in the economic cycle. I know Howard Marks says you can “master the market cycle,” but so far the market cycle has mastered me.

A wonderful company is the kind of company that I don’t have to sell after a bad quarter (because it might be a sign that everything is about to fall apart for them) or when the stock doubles (because it’s now a no-growth business trading a highish P/E).

I’m tired of investing in no-moat bad businesses and living through that kind of emotional turmoil, praying I’ll be able to unload it at a higher price in the future.

It’s a totally valid style of investing, but it’s just not for me.

I want to own the kind of company where it wouldn’t be a big deal if the market closed down for 10 years and I couldn’t sell. I highly doubt that I will actually hold these stocks for 10 years – but that’s the way I want to think about it before I buy it. If I would be terrified to be locked in for 10 years, then it probably doesn’t make sense to invest in it at all.

I don’t want to have to figure out some complicated sum of the parts situation. I don’t want to have to pray that an activist comes along and saves me.

I’m not looking to identify a cyclical trough in an industry and sell at a top. I don’t want to flip something after 6 months or a year and act like I’m holding a hot potato.

This is valid approach, but I have failed with this approach, so I’m trying something different.

Does price matter?

With all of that said, I still consider myself a deep value investor and only want to buy things trading at a compelling margin of safety.

I want to pay bargain basement multiples. I’m not going to do a bunch of mental gymnastics and put together a DCF that crashes Excel to find a margin of safety. I want it to be obvious.

Many people are perplexed by the fact that I demand such a low price. Why restrict myself to EV/EBIT situations around 10x?

After all, for the last 10 years, price hasn’t mattered much. You could buy a wonderful company at any price and make out okay. In fact, the people who sell wonderful companies when the prices get silly are often mocked. #Neversell, as they like to say.

I disagree with this. Price does matter. Simply because it hasn’t mattered throughout the current bull market does not mean that this environment will last forever.

It is a mistake to buy a wonderful company and not care about the price and history has taught these lessons repeatedly.

The Nifty Fifty Example

The Silent generation encountered this in the early 1970’s with the Nifty Fifty.

The Nifty Fifty were mostly outstanding companies. They checked all the boxes for a wonderful company. High ROIC. Strong long-term operating history. They could easily survive a recession. It didn’t take much imagination to envision continued growth.

In fact, most of them continued to be outstanding performers over the very long run. Most of them are still around and have exceptional long-term track records. Procter & Gamble. McDonald’s. Coca-Cola. Philip Morris. 3M. Walmart. American Express.

If you bought and held these Nifty Fifty stocks for 20-30 years, things worked out for you even though you paid a high price. Jeremy Siegel makes this point.

As Warren Buffett likes to say, time is the friend of the wonderful business. The Nifty 50 are proof of that.

Of course, no one actually buys and holds stocks for 30 years.

What happened from 1972-1982 was a different story: multiple compression. Multiple compression is when the price/fundamental ratios goes down. It’s an ugly situation where the business can continue to succeed, but the price suffers as the multiple declines. It’s a foreign concept to modern investors, but it happens.

Lawrence Hamtil wrote an excellent piece about the Nifty Fifty here.

Hamtil’s piece breaks down many of the track records of these companies for 10, 20, and 30 years.

While many of these excellent companies went on to have excellent 20 and 30 year returns (because time is the friend of the wonderful business), they delivered very poor results over the next 10 years from 1972-82.

Coca-Cola (the textbook example of a wonderful company), went on to deliver a 11.83% CAGR over the 20 years from 1972-92, but for the 10 years from 1972-82, is delivered a negative CAGR of 6.93%.

Coca-Cola continued to grow from 1972-82, but it didn’t matter. Multiple compression crushed the stock. It fell from the lofty heights of a 47.6x P/E multiple.

The same thing happened to Disney, another textbook example of a wonderful company. Disney – which traded at an 81x P/E in 1972 – delivered a -3.78% return from 1972-82. Because time is the friend of the wonderful business, it delivered a 10.81% return if you held through 1992, but who actually did that?

Everyone says their time horizon is long, but no one in the real world actually holds stocks that long. Everyone overestimates their real risk tolerance and time horizon.

This also assumes that during the Nifty Fifty you actually picked out the right companies. There were some that turned out to be long-term duds. Polaroid and Sears were also Nifty Fifty stocks, for instance.

The 1990’s

The same thing happened in the 1990’s.

Many people’s memories of the 1990’s bubble are foggy. They think it was all IPO’s like Pets.com. They think it was all cash burning garbage.

Modern FANGM investors scoff at comparisons of today’s great companies to the garbage bin of the 1990’s dot com craze. Google is certainly not a Pets.com, for instance.

The thing is: the bubble companies of the late 1990’s weren’t all garbage. The late 1990’s bubble included many exceptional companies and went beyond technology stocks.

Coca-Cola was one of them. In 1999, Coca-Cola traded at an EV/Sales multiple of 8x. The EV/EBIT multiple was 30x. From 1999-2009, it continued to grow earnings and sales, but it didn’t matter for the price of the stock. The EV/Sales multiple declined from 8x to 3x. The EV/EBIT multiple compressed from 30x to 10x.

The stock was essentially flat from 2000-09, delivering a .7% CAGR. The business continued to perform, but it didn’t matter for the investor in the stock.

Microsoft is another example. Like Coke, Microsoft grew its business from 1999-09. Revenues and earnings steadily increased. They maintained high returns on capital. Their moat wasn’t breached. However, the stock was essentially flat during the period, returning a .64% CAGR.

Wal-Mart wasn’t exactly Pets.com, but it still participated in the 1990’s bubble. In 1999, it traded at an EV/EBIT multiple of 40x. From 1999-09, it continued growing. The return wasn’t as bad as Coke and Microsoft, but still lackluster: only 3.63% and flat for most of the decade.

Some would say that this multiple compression was reflective of reality: two recessions, for instance.

I think that’s a little nuts. I don’t think it takes a genius to figure out, for instance, that a 30x or 40x multiple is high. Nor does it take a genius to figure out that Coca-Cola is probably going to make it through the Global Financial Crisis and people will continue to buy their products at the supermarket.

I don’t think wildly changing multiples are reflective of economic reality, which is what the EMH crowd would say. I think they’re reflective of the fact that people are crazy, Ben Graham was right, and the gyrations of the stock market are best described by the manic depressive mood shifts of Mr. Market rather than the elegant economic theories taught in classrooms.

Anyway, as history has proven, an exceptional business can deliver poor returns if you pay too high of a price. Investors in the 2000’s and 1970’s found this out the hard way.

This also assumes that you actually identified a wonderful business. What if you’re wrong? What if you think you’re buying Coca-Cola, Wal-Mart, and McDonald’s in 1972, but you’re actually buying Kodak, Sears, and Polaroid?

Many of the ‘buy wonderful businesses at any price’ investors will also console themselves in the work of Jeremy Siegel, who points out that if a Nifty Fifty investor held through the pain of the 1970’s, that they eventually made it on the other side okay. I think this is very unrealistic. My guess is that most people didn’t hold, and likely sold after a decade of poor performance.

Margin of Safety Matters

Buying a great business isn’t enough. A great business can easily experience multiple compression if bought at too high of a price.

Moreover, there are no guarantees that a great business will stay great. What if that dynamic changes? It’s one thing to buy a Microsoft at a high P/E and earn flat returns for 10 years and then make out okay after 20, but what if it’s not Microsoft? What if the business looks great today, but still falls apart?

I think you can use some common sense to identify great businesses, but I also think it’s possible you can be wrong about a few of them.

Multiple compression and the possibility of an error about the business are why I think a great business should only be purchased with a substantial margin of safety.

In my view, a portfolio of great businesses purchased at bargain basement multiples has a high probability of succeeding over the long run. If I buy at a cheap enough price, if the business doesn’t succeed, at least I didn’t pay too much. If the business succeeds, then I’ll get multiple appreciation on top of the performance of the business and the result will be outstanding. Meanwhile, multiple compression isn’t high on the list of concerns when bought at a 10x EV/EBIT multiple.

The darlings of the current era are probably wonderful companies. Most of them, anyway. I think the prospects of Google and Facebook are better than that of Netflix and Tesla.

But even in the case of Google and Facebook, I don’t think investors are thinking about the following questions: What if their multiples compress? What if we’re all wrong about the outstanding nature of these businesses and something happens where they cease to be wonderful companies? If we’re wrong about the business, multiple compression is going to be severe. If we’re right about the business, multiple compression can still result in a lost decade.

Even though price hasn’t mattered for the last 10 years, I still think price is important.

I think it’s a bad idea to abandon margin of safety and “never sell.”

Call me old fashioned: margin of safety is still an important concept.

Random

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Wonderful Companies at Wonderful Prices: Is It Possible?

Many think that value investors can’t buy great businesses.

I’ve even fallen into this trap, thinking that I will never buy a long-term wonderful company if sticking to strict value criteria.

Why would the market ever price a great company at less than 10 EV/EBIT, for instance? Surely if you want to buy a great company, you have to pay up. Right?

Warren Buffett likes to say that it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price. Modern investors have taken this too far, in my opinion. They buy wonderful companies at any price.

I have been doing a lot of fresh thinking about this topic after looking at the dismal results of my portfolio over the last three years. I’ve re-read all of my posts and it’s often humiliating how wrong I got many things. The most glaring example is my mistake made in March by not buying many great businesses selling for wonderful prices because I was too frightened by the macro picture and the overvaluation of the broader market. I still sit on a lot of cash as I think through these things, and the market continues to rip higher.

Rather than participate in the madness, I went back and re-read the Buffett letters. I also re-read Buffettology and The Warren Buffett Way.

These books have led me to think about a question: Why can’t we have it all? Is it possible to buy a wonderful company at a wonderful price? Is it so crazy to try to do this?

And note I’m not talking about a wonderful price in the sense that you did a DCF with high growth rates to justify a high multiple.

A DCF is much like torture and torture is not effective. Usually, the victim will tell you whatever you want to hear to make the pain stop.

It’s not like 24, where Jack Bauer quickly extracts a confession, yells Damnit Chloe!, and stops the villain before the episode is over. In the real world, it doesn’t work. DCF’s are the same, in my opinion.

By the time you approach your spreadsheet to perform a DCF, chances are you are already in love with the company and will mess with that spreadsheet until it gives you want you want to hear.

I’m talking about actually statistically cheap. A low multiple, such as below EV/EBIT 10. Does that ever happen with a great company?

I decided to take a look at some great businesses & great performers over the last decade. Did they ever sell for wonderful prices?

I turns out that they all have, at one time or another.

Apple

A great example is Apple.

Apple is without a doubt a wonderful company. It has a 10 year median return on invested capital of 31%. Operating margins are usually above 25%, implying pricing power. Earnings per share have grown at a 25% clip over the last 10 years.

The stock price has reflected the growth & quality of the business, advancing at a 32% CAGR over the last decade.

In February of 2016, Apple got down to 8x EV/EBIT. All of this information was already known about the business, but the price was still cheap over doubts whether the business would continue delivering these results.

Did any value investors pounce on this opportunity? Did anyone actually use fundamental analysis to identify this opportunity?

Warren Buffett did. Berkshire began acquiring Apple in 2016 when it was at this crazy price. It was also written up in value investor’s club at the same time.

Mastercard

Mastercard is a wonderful company. Mastercard’s operating margin is typically astronomical, over 50%. They have a moat around payments and have benefited as our society becomes increasingly cash-less. Free cash flow has advanced at a 40% CAGR over the last decade.

Mastercard went below 10x EV/EBIT in 2009. It also dipped below 10x a few times in 2010 and 2011. It didn’t get beyond 15x (still reasonable for a company with that kind of moat & quality) until 2014.

Did any value investors pounce? Turns out they did. In 2010, it was written up in value investor’s club. It was also purchased by Randolph McDuff, a fascinating value investor who utilizes EV/EBITDA in valuation criteria. I read about in The Warren Buffetts Next Door. His blog can be read here. This is a good article about him from 2008 in which his Mastercard investment is discussed.

Dominos

Domino’s is one of the best performing stocks of all time. Domino’s debuted on the public markets at the same time as Google. Shockingly, Domino’s outperformed. Since 2005, Domino’s has advanced at a 27% CAGR while Google has advanced at a 20% CAGR.

Over the last 10 years, Domino’s has grown free cash flow at a 17% CAGR. It has grown revenue at a 10% CAGR. Operating margins are consistently around 16-18%, a sign of a great business.

Shockingly, Domino’s – the stock that has outperformed Google – has traded for cheap multiples in the past. In 2011, Domino’s got down to an 8x EV/EBIT multiple. This is after they already adjusted their pizza recipe and after the stock already demonstrated excellence performance since their 2005 debut.

Did any value investor recognize this? Turns out that some did. Domino’s was written up in value investor’s club at this time.

It Is Possible

There are many other examples of this, particularly in the small cap space. I picked Domino’s, Mastercard, and Apple because they are mega cap stocks and everyone is already aware of their success. A truly efficient market would have never priced these widely followed wonderful companies below 10x EV/EBIT.

This all suggests to me that it is possible to have it all. Wonderful companies do sometimes sell for wonderful prices. Investors just need to be patient and move aggressively when these rare opportunities present themselves.

Random

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

With everyone freaking out about the “death” of the value investing, I thought I’d devote a blog post to my thoughts on why I think it’s much ado about nothing.

Also, for those who are easily triggered: I understand that value investing as a statistical factor is different from value investing as an analytical style used to evaluate the future cash flows of a company. When I talk about “value”, I’m talking about statistically cheap stocks.

The Value Anomaly

The academic literature treats value as an “anomaly.”

They say it’s a factor that explains anomalous returns. There is the market return, and value is a premium that you can earn over that. The hardcore EMH adherents will say that this premium is simply compensation for the additional risk of owning cheap stocks.

Size is described as another factor. This model explains why small-cap value has been the best investment strategy one could have pursued in the markets over the last 50 years or so.

If you knew that buying small, cheap stocks was a good idea on December 31st, 1971 and you could scrounge up $10,000 (assuming you could stop listening to Led Zeppelin IV and Who’s Next), you would now have $5,000,805, for a rate of return of 14.03%. If you opted for mid-cap value, you would have earned a 12.99% rate of return, which would have turned $10,000 into $3,234,830.

This compares to the US stock market return of 10.37%, which would have turned your $10,000 into $1,067,300. Large-cap value basically matched the performance of the US stock market, delivering a 10.3% return, which would have turned $10,000 into $1,035,393.

Actually implementing and sticking with the strategy would have been hard. There weren’t many low cost funds that could achieve this. You would have needed to do it yourself, which was hard in the era of high commissions. Moreover, you would have had to white knuckle it through some dicey times for the markets and the United States economy. Right after implementing the strategy in 1972, you would have lost 24.12% in 1973 and another 21.09% in 1974. I guess that most investors would have given up at that point, just when the strategy was about to rock.

Anyway, the “anomaly” exists. If you slice and dice it in different ways, other value factors work better. It’s also worth noting that the above results are based on price-to-book, which is a crappy way to describe value.

Is the value premium compensation for risk?

Value investing as a statistical factor is a subject of hot debate. There isn’t widespread agreement on what causes the premium.

The EMH crowd believes that the premium is compensation for heightened risk. Cheap stocks tend to be junky companies with uncertain futures, so they are riskier. Cheap shares in smaller companies ought to be even more dangerous, considering that a small company is more prone to failure than big companies. EMH adherents think of value and size in terms of a “premium” over the market return as compensation for risk.

I don’t agree with this. Take a look at the performance of small cap value during big, nasty, recessionary drawdowns. If value stocks are riskier, then the drawdowns during recessions should be more than the drawdowns for the broader market.

On average, small cap value declines with the broader market during recessions. However, the loss is typically limited to the broader market’s losses. In fact, it often outperforms.

On average, small cap value outperforms the broader market by 9.57%. Of course, this 9.57% average is skewed by the early 2000s, which was probably a freak event. This happened because in the late 1990s, small cap value was completely ignored by investors. Value investing famously fell out of favor in the late ’90s as investors became infatuated with the “new” economy. In 1998, small cap value suffered a loss of 2.68% while the broader market had an extraordinary 23.26% gain. In 1999, the pain continued. Small cap value delivered a paltry 3.35% rate of return while the market delivered 23.81%. As a result, entering the year 2000, the broad market was ridiculously overvalued and the value universe was overflowing with bargains that were ripe for multiple appreciation.

Even with that freak event thrown out, small cap value’s drawdowns are still limited to the market’s drawdowns during ugly recessions. If small cap value were a truly riskier strategy, the drawdowns should be a lot more severe than the broader market. This isn’t typically the case. In fact, small cap value still delivers a tiny premium of 2.53% for most of these terrible years, even when you throw out the early 2000s.

Small cap value doesn’t provide protection during most drawdowns, but the loss is usually limited to the market’s loss. If it were truly riskier, the losses should be much more severe than the broader market.

Meanwhile, value delivers incredibly robust returns when the economy is emerging from recessions and snapping back to life:

If small cap value were riskier, then these incredible returns in years like 1991 and 1975 should be offset by nastier drawdowns during recessions. However, this isn’t usually what happens. The drawdown is typically limited to the market’s drawdown and the recovery is usually more robust than the broader market.

And, this is using a crappy factor like price-to-book. If you use other factors like price-to-sales, price-to-earnings, or enterprise multiples – the results are a lot better.

This is also market-cap weighting value, which is further dragging down the returns. The returns in a value portfolio are usually in the cheapest securities, because they have the most runway to expand their multiples once the weather improves. The EMH adherents who treat value as a statistical anomoly usually market cap weight the value universe. They weight the stocks with the biggest market cap in the cheapo universe more heavily in the portfolio. A better approach would be equal weighting the universe or weighting the cheap names most heavily.

Underperformance

Meanwhile, value has underperformed for the last ten years, a phenomenon which is causing everyone to lose their minds and value managers to lose their jobs.

Value investors of the cheap variety are being mocked by everyone else who has bought the likes of Netflix and Amazon or simply invested in index funds. Most of the taunting amounts to “I bought VTSAX at 4 bps and made a ton of money, meanwhile these value nerds are killing themselves looking at cash flow statements and underperforming.”

Many of the value managers are capitulating to the bull market. They’re buying Netflix and Amazon and calling them value stocks because they’ve done a discounted cash flow model with optimistic assumptions about growth, margins, and interest rates. Then they quote something Buffett said about moats or Munger said about a tapestry of mental models. Ta-da, Netflix and Amazon are value stocks.

Since 2009, this has been the underperformance causing everyone to lose their minds:

Angels and ministers of grace defend us. Value investors have “only” earned a 13.82%  rate of return for the last decade. How can they possibly sleep at night? What do they tell their children? Do they wear scarlet letters at investment conferences, hanging their heads in shame? Are they dragged through the streets while a nun rings a bell and shouts shame?

Obviously, this is ridiculous. Value has held up with the market and underperforming slightly, but this is hardly the scarlet letter of shame that the headlines suggest.

Yes, there are prominent value investors who have fallen from the heavens of the early 2000s, but most of their underperformance is due to the fact that they made outsize bets on individual stocks or outright shorted the market.

In the 2000s, shorting expensive stocks plus concentration in a handful of “best ideas” amounted to leveraging up returns and, likely, leveraging up egos. A decade of massive outperformance inflated the egos and confidence of prominent value investors, which caused them to continue to doing the same thing into the 2010s. The market gods sniff out arrogance like a bloodthirsty wolf, and the same strategy that worked in the 2000s amounted to leveraging their returns to the downside for the last decade.

Meanwhile, systematic long-only value investors quadrupled their money and mostly kept up with the market.

By the way this the “underperformance” is discussed, you’d think that value investors are chugging bottles of Pepto Bismol after spending their nights drowning their tears of sorrow into plastic bottles of vodka because of their paltry 14% rate of return that quadrupled their money in a decade.

The truth is that the death of value investing has been greatly exaggerated. Sure, it has underperformed, but only because the indexes have performed so wonderfully in the last decade.

Flat Markets & Bull Markets

The key to understanding the “underperformance” of value is to understand that value isn’t a premium at all. It’s an idiosyncratic return that is correlated to the market, but not a premium over the market return.

The return is caused by multiples changing. A systematic quant value investor is simply buying a bunch of stocks at depressed multiples. Why are the multiples depressed? Usually, there is some bad news with the underlying business and cause for concern. Why do the multiples expand? Mean reversion, like a force of nature, improves the fortunes of these businesses. The prospects of the businesses improve through microeconomic forces (i.e., competitors go out of business, prices increase, prosperity resumes). Meanwhile, the prospects of hot businesses grow worse through the same microeconomic forces. When business is good, competitors swoop in and kill a good thing. The stock market, meanwhile, tends to extrapolate whatever is going on right now and projects it into the future. This creates a consensus and a depressed multiple. When that consensus is reevaluated for value stocks, multiples expand.

This process even happens in markets that are in a secular bear market, like Japan in the ’90s and 2000s. In Japan, for instance, the magic formula strategy delivered a 16.5% rate of return from 1993-2005 while the broader market was destroyed.

Multiples for stocks are always expanding and contracting in dramatic ways. Stocks with a P/E of 5 are going up to P/E of 10. Stock’s with P/E of 50 are going down to 25. Even if the broader market is flat, this process is constantly happening within the market. Throughout the market, the prospects of stocks are constantly being reevaluated and the market is assigning multiples based on Mr. Market’s mood swings at any given moment.

As an example of Mr. Market’s insanity, take a blue chippy stock like JPMorgan. JPM’s 52-week low is $91.11. JPM’s 52-week high is $119.24. That’s a 30.9% difference. Has the actual underlying value of JPMorgan changed by 30.9%, or is Mr. Market a little crazy?

It’s this compresion and expansion of multiples that drives the return in a statistical value portfolio. This is a return that’s correlated with the market, but it isn’t a “premium” the way that the academics describe it.

This is why value truly shines during the flat markets when nothing is happening for the indexes, earning a seemingly insane level of outperformance. Take a look at the performance of value during two bad periods for the indexes:

Meanwhile, value’s underperformance during bull markets is nothing new. When US stocks are doing well, value either matches the market’s return (the ’80s) or it struggles to keep up (the ’90s, the 2010s). With that said, even when the strategy underperforms, the returns aren’t terrible.

Why does value deliver a decent return even while the market is flat? This is because value is always doing its own thing. There are always going to be stocks with depressed multiples which later expand, even during flat markets. It’s not a premium over the market return: it’s an idiosyncratic return derived from multiples constantly changing. During bull markets, value is always going to underperform. The long-term outperformance takes decades to capture because it mostly occurs during flat decades like the 1970s and 2000s.

Technology’s Impact

I also don’t believe that that technology has destroyed value investing.

Value stocks have never been hard to find. Buffett combed through the Moody’s manuals in the 1950s. Investors in the 1970s could buy a copy of Value Line and find statistically cheap stocks. Now, investors can use screeners to find cheap stocks. Some say that this has elminated the “edge” for value investors. What these prognosticators of doom miss is that value stocks have never been hard to find. Value stocks have always been hard to buy.

It is hard to buy a stock with a depressed valuation. When you look at the company, there is usually good reason that the stock is out of favor. Everyone knows why they’re out of favor. Think about how ugly a New England textile mill looked in 1962 as it faced down cheaper competition. It’s just as hard as to buy the textile mill in 1962 as it is to buy a mall retailer facing reduced foot traffic in 2019. The hard part has never been identifying these cheap stocks, it’s actually going out and buying them. Technology makes it a little easier to find them, but it’s still just as hard to have the courage to buy them as it has always been.

There are also worries that the strategy has been overfarmed. Too many people are doing it. To which I ask: how many value funds out there have a significant active share in the cheapest stocks? How many fund managers have the cajones to really embrace the cheap stocks? How many are buying the truly out-of-favor securities? Most “value” funds and ETFs have an average P/E of 15 spread across hundreds of stocks. That’s hardly deep value land. They don’t actually buy the cheap stuff because few can handle the volatility and bouts of underperformance in a deep value portfolio. After a decade of underperformance, fewer are doing it than ever before.

Flat Markets & Bull Markets

Value investing, even of the statistical variety, isn’t going anywhere. The recent underperformance during a long bull market is nothing new.

If quadrupling your money in a decade causes you to throw in the towel, then buddy, maybe you don’t deserve the long-term value premium.

The outperformance, for those with a long time horizon, will come. It will come during the long stretches of time when the market is flat or delivering a low rate of return. I’m certain this is going to happen as much as I am certain that it will be cold in February. Markets are seasonal. They ebb and flow.

You might think that a flat market will never happen again. You might think that the market will deliver a 14% rate of return for the next ten years while every measure of market valuation is at historically insane levels. I think you’re probably wrong.

Valuations imply that we are in store for a decade of low returns. Pick your metric. Price/sales for the S&P 500 is at all time highs. Profit margins are at all time highs and profit margins usually mean revert. The CAPE ratio is 28.85. That’s not ’90s crazy (it was over 40 in 2000), but it’s currently where it was at the end of the 1920s boom. My favorite measure of valuation – the average investor allocation to equities – implies a 4-5% rate of return over the next 10 years. Vanguard agrees with that assessment and projects a 4-6% return for the next decade.

Those rates of return never happen in a straight line. A 5% rate of return is just the  average of crazy returns. We’ll probably have years over the next decade where the markets delivers a 30% positive return and somewhere there will be a terrible year where the market suffers a 50% drawdown again.

Maybe the Fed has eliminated the business cycle and the world is forever changed. If you believe that: please pass me whatever it is that you’re smoking.

I’m betting that the next decade will provide low returns for US stocks. Meanwhile, Mr. Market will continue to increase the multiples of depressed stocks as their prospects change. As value investors systematically buy stocks with compressed multiples that later expand, the returns for value investors will likely exceed that of the market.

Perhaps I’m wrong, but I think this is the likely outcome based on history and common sense.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

I came across this interview with Walter Schloss and it was packed with interesting quotes and insights.

Walter Schloss started his career on Wall Street in 1934 as a runner at the age of 18. He read Graham and Dodd’s Security Analysis and later went to work for Graham in his partnership. When Graham closed his partnership, Schloss went on to manage money himself. He managed money from 1956 through 2003 and delivered a 15.3% rate of return.

Here is what “Adam Smith” had to say about him in the 1972 book Supermoney:

“He has no connections or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it.”

Buffett had this to say about him:

“He knows how to identify securities that sell at considerably less than their value to a private owner: And that’s all he does… He owns many more stocks than I do and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That is one of his strengths; no one has much influence on him.”

While others deviated from the Grahamian value approach, Schloss stuck to it for the rest of his career. He started off buying net-nets. When net-net opportunities dried up and his capital expanded, he focused his attention on low price-to-book names.

Here are some great quotes from the interview:

1. Ben Graham: “In the ’20s he had a deal where he took 50 percent of the profits but he took 50 percent of the losses. And that worked great until 1929 when the market went down and obviously, his stocks were affected, too, and he was not only affected by that, but many of these people then pulled out because they needed money for their own purposes or they had lost a lot of money other places. So, he figured out how he could possibly never have this happen to him again. he was very upset about losing money. A lot of us are. So he worked on a number of ways of doing this and one of them was buying companies below working capital and in the ’30s there were a lot of companies that developed that way.”
2. Work at Graham-Newman: “Anyhow, at that time my job was to find stocks which were under valued. And we looked at stocks selling below working capital, which was not very many.”
3. Increasing positions in beaten up stocks: “Well, a lot of people don’t like it if you buy a stock at $30 for a customer and then they see it at $25. You want to buy more of it at $25. The guy doesn’t like that and you don’t like to remind him of it. So, one of the reasons I think that you have to educate your customers or yourself, really that you have a strong stomach and be willing to take an unrealized loss. Don’t sell it, but be willing to buy more when it goes down, which is contrary, really, to what people do in this business.”
4. More on undervaluation: “Basically we like to buy stocks which we feel are undervalued and then we have the guts to buy more when they go down.”
5. Why the “superinvestors” who worked for Graham succeeded: “I think number one none of us smoked. We were all rational. I don’t think that we got emotional when things went against us and of course Warren is the extreme example of that.
6. On buying foreign stocks: “Well, my problem with foreign companies is I do not trust the politics. I don’t know enough about the background of the companies. I must tell you, I think the SEC does a very good job and I feel more comfortable holding an American company.”
7. Selling: “Sell is tough. It’s the worst, it’s the most difficult thing of all and you have an idea of what you want to sell it at and then you sometimes are influenced by the changes that take place. We owned Southdown. It’s a cement company. We bought a lot of it at 12 1/2. Oh, this was great. And we doubled our money and we sold it at something like $28, $30 a share and that was pretty good in two years. When next I looked it was $70 a share. So, you get very humbled by some of your mistakes. But we just felt that at that level it was, you know, it was not cheap.”
8. Shifting from net-nets to low price-to-book: “Yes, it’s changed because the market’s changed. I can’t buy any working capital stocks anymore so instead of saying well I can’t buy em’, I’m not going to play the game, you have to decide what you want to do. And so we decided that we want to buy stocks if we can that are depressed and have some book value and are not too, selling near their lows instead of their highs and nobody likes them.”
9. Q: Tweedy Browne is very quantitative, and Buffett’s more qualitative. Where are you in that spectrum? A: “I’m more in the Tweedy Browne side. Warren is brilliant, there’s nobody ever been like him and there never will be anybody like him. But we cannot be like him. You’ve got to satisfy yourself on what you want to do. Now, there are people that are clones of Warren Buffett. They’ll buy whatever Warren Buffett has. Fine. I don’t know, I don’t feel too comfortable doing that and the other thing is this. We happen to run a partnership and each year we buy stocks and they go up, we sell them and then we try to buy something cheaper.”
10. Why he didn’t pursue Buffet-Munger style concentration: “Psychologically I can’t, and Warren as I say, is brilliant, he’s not only a good analyst, but he’s a very good judge of businesses and he knows, I mean my gosh, he buys a company the guy’s killing himself working for Warren. I would have thought he’d retire. But Warren is a very good judge of people and he’s a very good judge of businesses. And what Warren does is fine. It’s just that it’s not our — we just really can’t do it that way and find five businesses he understands, and most of them are financial businesses, and he’s very good at it. But you’ve got to know your limitations.”
11. Selling short: “We did it a couple times and we’re always very upset after we do it. So I’d say not anymore.”

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

 

Has the bull market erased bargains?

I was listening to an investing podcast the other day and heard an interesting conversation. The guest pointed out that during the internet bubble of 1999, there were a significantly higher number of bargains than there is today. The guest further lamented that in the current environment, the bargains aren’t as widely available as they were back then.

This is an important point. As discussed in my previous post, growth has trumped value for some time now, which is a historical aberration. The disconnect will certainly end, but it’s difficult to say when and how it will happen.

The resolution in the early 2000s of the value-growth disconnect was the ideal situation. The broader market entered a tailspin for nearly three years, but value experienced a significant bull market at the same time, seemingly disconnected from the carnage that took place in large cap stocks.

This is obviously how I would like to see the current situation shake out, but I suspect that the value bull market of the early 2000s was due primarily to the number of bargain stocks that were available because everyone was fixated over the likes of Qualcomm, Cisco, Amazon, Redhat, etc.

I decided to take a look at the data for myself. I looked at the number of earnings bargains available in 1999 and compared them to today, as well as a few other points in time in recent market history. The universe of stocks I looked at was the S&P 1500. The data is below.

Bargain Availability Through the Years

Bargains were available in 1999, but certainly not to the extent that existed during the financial crisis. In 1999, there were 102 stocks with an earnings yield over 10%. As a group, they returned 18.10% in 1999. The number rose to 171 in 2000, and the return was 32.47% for that year. This occurred while the S&P 500 experienced a decline of 10%.

By 2005, the number of stocks yielding over 10% shrunk to 50 and the group returned 8.26% that year, slightly below the S&P 500’s return of 11% that year.

Obviously, the greatest moment in history to buy value stocks was early 2009. At the beginning of 2009, there were 474 stocks (nearly 1/3 of the universe) with an earnings yield over 10%. As a group, they returned 62.78% throughout 2009.

The number of bargains shrunk to 158 in 2012. The population shrunk as we emerged from the financial crisis, but bargains were still more plentiful than they were in the 1999-2008 period. As a group, they returned 10.26% in 2012 and 50.96% in 2013.

Today, the number has shrunk to 64. This is lower than 1999, but it hardly seems as if bargain stocks are no longer available. They are still out there, they are still behaviorally difficult to buy, and this suggests to me that the value premium will remain alive and well. However, I think that the low availability makes it unlikely to value’s resurgence will play out like it did in the early 2000s.

That ’70s Stock Market

The key question is how all of this will play out. History suggests that bigger populations of bargain stocks bode well for future returns. It’s not an iron clad rule that you could plug a formula into, but that’s the general trend.

This suggests that value is limited but not eliminated in today’s market. It also seems unlikely that we will experience a resurgence of value as incredible as that of the early 2000s when value experienced a bull market while the broader market declined.

I would like to believe that this will occur again, but I doubt we will be that lucky.

I think a more likely scenario for the next shakeout will be something more like the 1970s. The late ’60s and early ’70s was one of those times (like the late ’90s and today) where growth trumped value and the S&P 500 soared.

In the early ’70s and late ’90s, everyone preached buy and hold while it worked and few practiced it once times became tough. In all of these eras, popular sentiment was that value investing was dead and that everyone who wasn’t buying sexy growth names was a relic of the past who just didn’t understand how magical the new era was, paying 50 times earnings makes sense because . . .  Copy machines/dial-up-internet/smart phones/blockchain, it’s a new era, markets are so efficient and competitive these days, blah blah blah.

When the shakeout went down in the ’70s, value stocks fell with the broader market. They didn’t experience a bull market like they did in the early 2000s.

For a good look at value returns during this period, I took a look at this analysis of the simple Ben Graham strategy over at Alpha Architect. I also thought a good record to examine were the annual returns of Walter Schloss, whose strategy focused on low price-to-book names. Below is a snapshot of the 1970s from the perspective of the S&P, Walter Schloss and the systematic low P/E low debt Ben Graham strategy.

As you can see, in the 1970s, value delivered the highest returns, but the road was bumpy. Unlike the early 2000s, value didn’t go up while the broader market declined. Value stocks went down with everything else.

During the 1973-74 bear market, Walter Schloss held up better than both the broader market and the systematic Ben Graham approach (a variation of which I’m following with my portfolio). I suspect that Walter Schloss’ decent performance in the recession of 1973-74 is due to his zero exposure to the Nifty Fifty and I also suspect that he held a significant amount of cash.

Walter Schloss was a classic Graham investor focused on asset value. If the bargains weren’t available, he didn’t buy them. This allowed him to experience only single digit losses during the 1973-1974 period.

The systematic Ben Graham strategy didn’t hold up as well, but I think that’s likely because it was fully invested while Walter Schloss was not.

The Future

I don’t know what the future holds, but I do know that buying expensive hyped up stocks is dangerous, regardless of how seductive it looks in the throes of a late bull market. Value will outperform growth and the broader market over time, but the road will be rocky and require patience. In investing, I think patience and discipline are more important than any other characteristic, including intelligence.

While I would love to see a repeat of the early 2000s value bull market, I don’t think we will be that lucky. Due to the fewer bargains available today than were available in the 1999-2000 period, I think a repeat of the 1970s is more likely, which was painful at times, but ultimately rewarding to those who had the patience to stick with a value approach and the discipline to avoid the sexy glamour stocks.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.