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.
Like most value people, I was glued to my TV on Saturday night to the Buffett meeting.
It was one of the best and the most candid Berkshire meetings I have ever watched. Becky Quick did a great job at filtering questions. The questions were all of high substance, without a lot of fluff. There was not an opportunity for people asking “questions” to give 15 minute speeches, for instance.
I also got a real kick out of Buffett’s black-and-white and all-text slide presentation. It’s a sharp departure from what most of us experience in our day jobs.
With a slide deck, how much attention do we pay to presentation? Does any of that style really add any value to the presentation? Probably not. Buffett is a guy who doesn’t care about that sort of thing. He always gets across his point as simply as possible. The rest of us – me included – tend to over-complicate it.
Anyway, Warren Buffett needs to tow a fine line when commenting on markets and the economy. His words can move markets. He was very careful with his words this year, expressing short term caution and long term optimism. He didn’t give an exceptionally candid call on markets.
The last two times Buffett was exceptionally candid about his views on the market were 1999 and 2008. Back in 1999, he gave a famous speech at Sun Valley in which he questioned investor’s expectations and was quite bearish. He called out the internet bubble and overall market extremes. In 2008 and 2009, he took a different point of view and was extremely bullish. In October of 2008, he wrote an opinion piece called “Buy American, I Am” in which he talked about how stocks were cheap and poised for a great future.
This year, Buffett didn’t outright express his bearishness, but I think it was buried in there. If Buffett were outright bearish, he could trigger a crash. I think he’s aware of this. His words expressed caution.
He noted that he hasn’t been buying stocks and sold out of one industry (airlines) completely.
His actions, as opposed to his words, speak volumes. He didn’t back up the truck like a lot of investors did in March. Through his comments about the wide range of probabilities with the virus, I think he was preparing everyone for the fact that the ugliness might not be over for the markets and the economy, which is a sharp contrast to the actual behavior of the markets, which seem to be predicting a swift return to normalcy.
He praised the Fed’s actions to contain the crisis and put Jerome Powell in the same place as Paul Volcker. I agree with him on this point. I think markets are expensive, but I also don’t think that the Fed should let the world burn so I can buy stocks below net current asset value.
With that said, even while praising Powell’s decisive action in ending the crisis, he did take note that today’s unprecedented actions will have long term consequences. I also agree with him there. We are in uncharted territory with monetary policy.
Of course, Buffett also spoke about America’s bright long term future. This was the focus of his initial presentation. Starting off with this speech was a careful move to put his short term caution into context. He expressed his long-term optimism in the future of the country and the prospects for our economy, despite his short term caution about markets and the economy.
Also, Warren talked about how Ben Graham was one of the three smartest people he had ever met. He didn’t mention the other two, but I suspect they are Bill Gates and Charlie Munger.
If you didn’t watch it, I’d recommend checking it out at the below link. Buffett starts in the video at 1:00:33 with his presentation about the long-term future of the country. The really good part – the Q&A – starts at 3:07:20.
I’ve never been to a Berkshire meeting before, but I definitely want to attend in the future.
One of the most common criticisms I get from other value investors is that I trade too much. This is mainly because value investing has come to mean whatever Warren Buffett says it means.
Buffett recommends that the best holding period is forever. Buy a great business at a fair price and hold onto it for decades. This has become the commonly accepted wisdom among value investors.
Buffett’s views on holding periods is best summarized by the below quotes:
Our favorite holding period is forever.
Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years
My activity is entirely inconsistent with this philosophy.
I argue that Buffett’s approach is only one method of value investing.
It is a perfectly valid approach. But it’s not the only valid approach.
Graham: Two Years or 50%
Graham had a different view. It is also one that makes more sense to me. Graham’s view was that an investor should calculate a stock’s intrinsic value, buy below that intrinsic value, and then sell when it reached that intrinsic value. In other words, Graham believed in simple, easily comprehensible, rules-based value investing.
This is different from holding onto stocks in great businesses for decades on end no matter what.
Graham explained his rules in the following interview:
Q: How long should I hold onto these stocks?
A: First, you set a profit objective for yourself. An objective of 50 percent of cost should give good results.
Q: You mean I should aim for a 50 percent profit on every stock I buy?
A: Yes. As soon as a stock goes up that much, sell it.
Q: What if it doesn’t reach that objective?
A: You have to set a limit on your holding period in advance. My research shows that two to three years works out best. So I recommend this rule: If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price. For example, if you bought a stock in September 1976, you’d sell it no later than the end of 1978.
In other words, Graham recommended that an investor should sell a stock after a 50% gain or after holding for two years, whichever comes first.
This view makes sense to me.
I estimate what I think something is worth, then I sell when it hits that value. I don’t think I’m capable of figuring out which stocks among the thousands available in the investable universe will overcome the odds and compound for decades on end. I do think I’m capable of identifying a bargain and selling when it is reasonably close to its intrinsic value.
There are drawbacks to this strategy. I will never own a stock that compounds throughout the decades. I’ll never buy and hold Nike for 40 years. I’ll never become a millionaire by investing in the Amazon IPO.
I also don’t care. I can achieve perfectly satisfactory results without trying to buy these lottery tickets.
My approach is a high turnover approach, which increases costs and taxes. This is a big deal for someone like Buffett and not so much for me. Buffett is a megaladon and I’m a gnat in the belly of minnow. My trading account that I track on this blog is in an IRA and brokers don’t charge commissions any longer. I have miniscule sums of money and I can’t influence the price of a stock.
My strategy isn’t scalable, either. At least, it’s not scalable to Warren Buffett’s level. Warren Buffett commands the one of the largest pools of investable cash (that is constantly growing!) in global markets. He can’t nimbly move in and out of stocks. It’s like an elephant trying to nimbly move in and out of a swimming pool.
Buffett’s strategy is entirely valid, but it’s not the only valid strategy.
What’s a Wonderful Business?
Buffett recommends buying wonderful businesses. Well, what’s a wonderful business?
A wonderful business is a business that can earn high returns on capital over long periods of time.
This is extremely hard to do. It’s extremely hard to do because we live in a capitalist economy with a lot of competition. If someone has a business where they can earn high returns, other businesses are going to swoop in and do the same thing, which will reduce those returns.
This is why Warren Buffett focuses so much on the concept of a moat. Those high returns on capital can only be sustained if there is something about the business that helps it resist competition.
Where do moats come from? They can emerge from a lot of places. Some businesses might have a geographical moat, like a toll bridge. Others might have a regulatory moat, where government policy helps sustain their advantage. Brands are another form of moat. Are you willing to pay a premium for a Nike swoosh? You likely already have, many times over.
Buffett has identified many moats in good brands. After successes with other wonderful businesses such as American Express and Disney in the 1960’s, Buffett recognized the power of a moat through his investment in See’s Candy in the early 1970’s.
See’s Candy can earn high margins because it has a recognizable and enduring brand. Munger explains the moat below:
“When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s.”
People are willing to pay a premium for See’s because of the enduring quality of the brand. That’s not something that an upstart competitor can easily disrupt.
The same is true for Coca-Cola. Coca-Cola has a strong brand. If you face a choice between a store brand Cola and Coke, you’re going to pick Coke.
It won’t make much of a difference in your personal finances or grocery bill if you pay 40 cents a can versus 30 cents a can. Why wouldn’t you chose a marginally more expensive quality brand that you’re familiar with over one that you have no familiarity with? Meanwhile, that small difference in price creates large profit margins that are sustainable over long periods of time.
Moats Are Hard to Find
Situations like Coke and See’s sound deceptively easy to identify.
A key problem is that moats are much harder to identify than we realize.
The concept of moats was popularized by Buffett, but it is rooted in the ideas of Michael Porter.
The ideas of Michael Porter have been widely disseminated throughout business education programs. In the 1980’s, it was first taught at the Ivy Leagues. By the 2000’s, it was disseminated and understood far and wide.
My MBA is about as far away from the Ivies that you can go. I earned my MBA at a cheap state school, but even I was taught the gospel of Michael Porter. Much like the efficient market hypothesis, which was drilled into my head during my Finance undergrad degree, Porter’s ideas were treated as gospel truth.
There’s a problem with the ideas of Michael Porter: there isn’t any proof that any of it is true. Dan Rasmussen explains much better than I ever could in this excellent article in Institutional Investor. Rasmussen explains:
Porter’s logic suggests that firms with competitive advantage would earn excess profits, so profitability margins should be a guide to which firms have the most-sustainable profit pools. Yet profit margins have no predictive power in the stock markets. In fact, academic research suggests that margins are mean-reverting and provide little information about future profitability. The implicit certainty of Porter’s view of the world — that margins are persistent, that competitive advantages result from permanent structural features of industries, that “excess profits” come only from distortions in market structure — could lead investors to overpay for current performers. The theory leads not to an investing edge, but to the most common of investing mistakes.
It’s harder than hell to distinguish between a business that is enjoying a temporary edge between one that is an economic franchise.
It’s also hard as hell to figure out if an economic franchise which has endured for decades is about the completely fall apart. One of the best examples of this is Kodak. In the 1990’s, Kodak looked like it had an impenetrable moat. Then digital cameras came along.
Morningstar has put significant resources and intellectual depth into identifying moats. As highlighted in this excellent article by Rupert Hargraves, companies christened as “wide moat” don’t outperform over the long run like they theoretically should. Are you a better analyst of a moat than the talented people at Morningstar who have devoted themselves to solving this problem?
The same phenomenon is also highlighted by Tobias Carlisle in Deep Value. Carlisle cites Michele Clayman’s analysis of Tom Peter’s book “In Search of Excellence” as an example.
In the early 1980’s, Tom Peters identified key attributes of “wonderful” companies and assembled a list of truly wonderful companies. These were companies with high growth rates and high returns on invested capital.
In 1987, Michele Clayman analyzed the stock performance of these “excellent” companies. The portfolio underperformed the S&P 500.
Adding insult to injury, Clayman also assembled a list of companies with the opposite characteristics of excellence – bad returns on capital, low growth rates. Guess what? The unexcellent portfolio outperformed both the S&P 500 and the “excellent” portfolio by a wide margin.
Of course, a modern value investor would argue that they weren’t really excellent companies because they didn’t have a moat to defend those high returns on capital.
These investors would say that the companies that they are purchasing today actually have a moat. Okay. What’s more likely? That these investors have found a moat or a business enjoying a temporarily good situation that will ultimately be eroded by competition? I would say that the evidence suggests they are unlikely to find a moat.
Coca Cola: A Case Study in Moats
The Moat
Buffett gobbled up Coca-Cola shares after the stock market crash of 1987. He knew Coca-Cola was one of the ultimate American brands and had a strong moat which allowed it to earn high returns on invested capital.
A key source of Coke’s moat was its long and successful marketing campaigns. Coke was everywhere for 100 years. Baseball games. Logos printed on every billboard. Indelible images pounded into the American psyche, like Santa Claus drinking an icy cold Coca-Cola and smiling.
The success of Coca Cola’s marketing was best demonstrated during Coca-Cola’s debacle with New Coke. In 1985, Coca-Cola tried to change their formula. They tested out their formula in taste tests and people preferred it.
Once the new flavor was released, the public hated it. Coke executives quickly realized that Coca-Cola’s success had nothing to do with the actual taste: it had to do with the public perception of the Coca Cola brand, which Coke spent decades establishing. The people associated messing with Coke’s flavor with messing with a part of Americana itself. Coke ultimately relented and brought back the old flavor in the form of “Coca-Cola Classic.”
This is a great documentary from 2003 on the debacle, the People vs. Coca-Cola.
I grew up on a steady diet of Coke marketing and Coke products. Coke’s aggressive marketing has made me associate that brand with an image of America itself.
The sugary sweetness was an immediate appeal. The sugar and caffeine high that came afterwards made me feel good. It was usually served to me at happy occasions: family events, movies, birthday parties. My mind quickly associated the taste of Coca-Cola with good times and good feelings.
Generations of children had the same experience. This made for a hell of a moat, probably the ultimate moat in the history of business.
A Wonderful Business at a Fair Price
Modern value investors are obsessed with identifying Coke-like businesses. They want to identify these wonderful businesses at fair prices and hold onto them for decades of compounding success, following Buffett’s example.
As justification for their frothy purchases, they cite Buffett’s transformation from buying stocks below working capital to buying wonderful businesses at fair prices.
Of course, the price of Buffett’s Coke purchase was hardly modern compounder territory. Buffett bought Coke at a P/E of 12.89 in 1989 and 14.47 in 1988.
Furthermore, I think that Buffett holding onto Coca-Cola for decades was a mistake. He should have sold it in the late ’90s.
Coca-Cola has treated Berkshire exceptionally well. Coca-Cola has compounded at a 13% rate since 1986 in comparison to the stock market’s rate of 10% during the same period. In other words, Coca-Cola turned a $10,000 investment into $660,653. The US stock market turned the same $10,000 into $270,528.
What is missing from the raw CAGR is the sequence of these returns. From 1986 to 1998, Coca-Cola grew at an astounding CAGR of 27.68%. However, from 1998 through 2020, Coke has only appreciated at a CAGR of 4.74%. 10 year treasuries have returned 5.31% with a lot less stress.
An investor would have been better off investing in 10-year treasuries in 1998 than investing in Coca-Cola.
Did Coca-Cola’s business change? No. Coca-Cola has continued to be a great business since 1998, growing earnings and earning high returns on invested capital. It didn’t matter for the stock.
What changed was the price. Coca-Cola got up to a P/E of 40x in 1998. The price grew faster than the fundamentals.
The valuation mean-reverted in the 2000’s despite the performance of the underlying business, causing the less than satisfactory result.
Buffett should have sold Coca-Cola in the late ’90s, but he didn’t.
Why didn’t he?
It could be for public image reasons. Berkshire had become so closely associated with the company. If Buffett sold, it would be a blow to the public image of Berkshire and Coke.
He also couldn’t nimbly move out of it, as it had grown into a massive portion of the Berkshire portfolio.
In fact, it’s quite possible that Buffett realized Coke was expensive, couldn’t sell for the public image reasons, and this may have been a major reason that Berkshire purchased General Re, which helped dilute Coke as a percentage of Berkshire’s holdings.
I’d also argue Buffett was in love with the business and couldn’t bring himself to sell.
Problems with Wonderful Businesses
Coke’s price run-up in the ’90s and Buffett’s mistake by holding on outlines a major problem with buying wonderful businesses.
If the business is indeed wonderful, how can an investor bring themselves to sell when the price gets ahead of the fundamentals?
Another major problem with moat investing is that moats are ridiculously hard to identify. I would argue that even Coca-Cola’s moat isn’t certain to persist into the future.
While it was socially acceptable to give children sugar water when I was a kid, that dynamic is different today. Coke has tried to get away from this problem by diversifying into other products. Still, I find it hard to believe that Dasani will have the same marketing grip over future generations that Classic Coca-Cola had over previous generations.
If Coke’s moat is uncertain, then what moats are certain?
If it’s possible that Buffett – the greatest business analyst of the last hundred years – is making a mistake by holding Coke, then what are the odds that you going to make a mistake by buying the business that you think has a wide moat? I am certainly not a business analyst that’s as good as Buffett.
It is also increasingly difficult to acquire these businesses at “fair” prices. Investors fall in love with wide-moat businesses and bid them up to prices which are likely going to create disappointing future results.
For example, modern value investors are buying things like Visa and Costco because they are wonderful businesses with moats.
I certainly agree that, on the surface, Visa and Costco have incredible moats. Visa controls a significant portion of the global payment system and it’s unlikely that a competitor can disrupt that. Costco controls an ever increasing portion of America’s retail spending habits and maintains that by maintaining low prices and locking in consumers with memberships.
Neither of these businesses can be acquired at the kind of “fair” prices that Buffett acquired companies like See’s and Coca-Cola.
Look at the current EV/EBIT multiples of these wonderful businesses:
Coca-Cola – 24.14
Costco – 19.91
Visa – 23.42
Additionally, Buffett didn’t buy Coke and See’s at crazy, or even slightly high, prices. They were incredible bargains!
As mentioned earlier, for Coke, Buffett bought it at a P/E of 14 and 12. The enterprise multiple was likely much lower than that raw P/E suggests. See’s was purchased for $25 million. Sales were $30 million the year that he bought it. Profits were $4.2 million.
Buying a company for less than its annual sales and at a P/E of 5.95 is nothing like buying today’s compounders at EV/EBIT multiples over 20.
Yes, See’s wasn’t a net-net, but it was hardly a situation where Buffett and Munger threw caution to the wind and paid a sky high valuation for a great business that compounded over time.
Do I Trade Too Much?
Let’s return full circle to the question I asked at the beginning. Do I trade too much?
I don’t buy wonderful businesses and hold them for all the reasons described above. I buy cheap stocks and then get out when the fundamentals deteriorate or they get close to intrinsic value. I certainly trade more than the Buffett-style compounding value investors, who would waive a ruler at me like a nun in Catholic school for betraying the faith.
I went to Catholic school and this was a frequent occurrence.
I trade even more frequently than Graham’s rules recommend.
Not only do I sell at intrinsic value, I often sell at mere 52-week highs. I’ll also sell if I notice a deterioration in the performance of the business, often relatively quickly after I buy them.
A major reason I sell so quickly is because I know I’m not necessarily buying wonderful businesses. I’m buying businesses at what looks like a bargain price regardless of its underlying quality. I get out when I see signs of a deterioration in the business, which helps me avoid value traps.
I’d argue that the approach works, even though I’ve lagged the S&P 500.
As with all things, I like to look at the evidence and not the dogma.
Here is a comparison of stocks I’ve sold, comparing my sale price to the current market price.
I’m not following the Buffett scriptures, but it seems to me like I’ve made some pretty decent sell decisions.
I think I will continue to follow my own path instead of sticking to an investing religion dogmatically.
Summary
Buffett believes in long term holding periods. Graham recommending shorter periods. I agree with Graham.
Wonderful businesses with moats are extraordinarily hard to find. It’s also hard to find in any quantitative sense.
There isn’t any empirical evidence that proves that wonderful businesses outperform over long periods of time. In fact, the opposite is true.
I get criticism for trading too much, but it seems to be working out for me. I’m going to chart my own path and not stick to an investing dogma like it’s a religion.
You do you. There isn’t any one true faith in investing.
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 ValueAnomaly
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.
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.
Prior to reading Deep Value by Tobias Carlisle, I always thought that the key in value investing was to find cheap companies that could grow fast.
Buffett even discussed the merits of combining growth and value in his 1992 letter:
Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.
We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
A key point of Tobias’ book is that growth is not how value delivers returns. The discount from intrinsic value and the closing of that gap is the key driver of return in a value portfolio.
De Bont & Thaler
He cites two studies in the book that are compelling because of how counterintuitive they are. They were both conducted by Werner De Bondt and Richard Thaler. The first study looked at the best-performing stocks and compared them to the worst performing stocks in terms of price performance. They found that the worst performers go on to outperform the best by a substantial margin.
They also looked at this in terms of fundamental earnings growth. They reached the same conclusion: the worst companies outperform the best.
A Simple Backtest
I decided to backtest more recent data myself to see if this still holds true. In an S&P 500 universe, I performed a backtest going back to 1999. I compared the performance of the 30 companies with the fastest growth in earnings per share to a portfolio of the 30 worst stocks, rebalanced annually.
Just as De Bont & Thaler determined before, the 30 worst companies continue to outperform the 30 best.
Keep in mind: there is no other factor involved here except for 1-year earnings growth. We’re not even looking at these stocks in a value universe: it’s simply the 30 fastest growers vs. the 30 worst.
Value Drives Returns
The evidence suggests that value alone is the best determinant of future returns. Growth isn’t nearly as powerful.
For instance, I also tested the performance of a universe of stocks with a P/E less than 10. This universe of stocks delivered an 11.69% rate of return since 1999. Within this winning universe, if you bought the 20 stocks with the best earnings per share growth then the return actually declined to 9.77%. Fast growing value stocks actually underperform the overall value universe.
The same is also true from a macro standpoint. Looking at the performance of the S&P 500 since the 1950s, the greater determinant of future returns is starting valuation, not actual business performance.
As you can see, the valuation of the market at the start of the decade (Shiller CAPE and the average investor allocation to equities – both valuation metrics are discussed in this blog post) are far more predictive of future returns than actual business performance.
Look at where the divergence is widest — the 1980s versus the 2000s.
The 2000s was a much better decade than the 1980s in terms of actual business performance. During the 2000s, earnings grew by 191%. In the 1980s, earnings only grew by 16.40%.
However, the 1980s witnessed a 409% total return for the S&P 500, while the 2000s actually clocked in a net decline of 9%.
Of course, there were macro events driving both markets. In the 1980s, returns were bolstered by interest rates declining from all-time highs once inflation was brought under control. At the end of the 2000s, we suffered the worst financial crisis since the Great Depression and the worst recession since the early 1980s, which negatively impacted stocks at the end of the decade.
With that said, the key factor behind the returns was the overall valuation of the market, not macro events or even business performance.
The undervaluation of the US market in the early 1980s was the true force that propelled the bull market forward. In 1980, the Shiller CAPE for the US market was 8.85 and the average investor allocation to equities was only 23%.
In contrast, the overvaluation of the US market in 2000 was the key force that drove down returns over the next decade. In 2000, the Shiller CAPE was 43.77 and the average investor allocation to equities was 50.84%. Actual corporate results were impressive but that wasn’t enough. Valuation mattered more.
Conclusion
The conclusion is both simple and radically counterintuitive: valuation matters more than growth in predicting future returns for a single company stock or an entire market.
In the long run, growth simply doesn’t bring much to the party.
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:
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.”
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.”
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.”
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.”
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.
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.”
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.”
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.”
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.”
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.”
Selling short: “We did it a couple times and we’re always very upset after we do it. So I’d say not anymore.”
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.
Value investing has been enduring a tough time. This is certainly true for my own portfolio. I’m down 7.72% year to date compared to an 8.34% gain for the S&P 500. It’s times like this that it helps to look to history.
We’re currently in an era where investors are gobbling up growth companies and they don’t care what the price is. I remember the same mood back when I was in high school. People forget, but the bubble wasn’t simply concentrated in dot-com stocks. The bubble was pervasive among even the most stable of blue chip companies: Cisco, Microsoft, Coca Cola.
Going further back in history, the same euphoria characterized the Nifty Fifty era. The Nifty Fifty was a group of 50 stocks in the early 1970s that grew by leaps and bounds in the 1960s. Many of them were exceptional companies (like McDonalds and Xerox), but the euphoria pushed their valuations to extraordinary levels. Predictably, valuations came crashing down and investors were burned.
Taking things back even further, the same mood characterized the South Seas bubble. That bubble was fueled by optimism over the age of exploration and it famously burned Isaac Newton. Newton remarked of the collapse: “I can calculate the movement of the stars, but not the madness of men.”
Every bubble has something in common. There is something new and exciting in the air that promises to change our lives and this fuels speculation. It starts with a truth (i.e., real estate is an excellent investment for the middle class) and then descends into temporary madness. Of course, the market always corrects this madness. Eventually.
During the dot-com bubble, it was the promise of the internet. The internet was going to transform the way we live and everyone could see it . . . so, Cisco Systems was valued more than General Electric and Pets.com was a thing. They were right about the promise of the internet but wrong about the impact on stocks. Adding fuel to the fire was the promise of the “new economy”. Productivity was surging at the time. Productivity is the key ingredient in economic growth, so the belief was that we were entering an era of permanently higher growth. This fueled predictions of the federal budget deficit going to zero in 10-20 years. In truth, productivity was simply reverting to the mean after stagnation in the 1970s and 1980s. Keep this in mind when commentators say that the current productivity slump is permanent and means that the US economy will never grow faster than 2%.
With the Nifty Fifty, it was optimism about the power of the post-World War II American economy. The 1950s were a good time for the American economy and the 1960s were even better. The unemployment rate was only 3.9% by the end of the decade. Americans experienced abundance that was foreign to them in the past. Suburbs popped up everywhere and car ownership became ubiquitous. In the 1970s, the good times took a hit due to inflation, an oil shock, and the confidence-sapping Watergate scandal. Also, disco. Unaware of what was about to happen, investors thought that you could simply buy the fastest growing companies in the world’s fastest growing economy, and price didn’t matter.
With the South Seas bubble, it was the promise of the age of exploration. The New World opened up two continents that were rich in natural resources and abundance. Surely, investing in the company that would dominate trade in the new era was a surefire bet.
Now, the euphoria is fueled by the promise of scaled up e-commerce in the form of Amazon, cryptocurrency (personally, I only trust a currency that is secured by the full faith and credit of people with guns, aircraft carriers, stealth planes and nuclear weapons), the transformation of our lives by smartphones and the promise of whatever Elon Musk thinks is cool (electric cars, cars that drive themselves, hyper loops, USB ports in our brains, etc.)
Euclidean Technologies Q2 2017 Letter
I was reading Euclidean Technologies Q2-2017 letter and came across this historical nugget:
“Among large-cap stocks, the spread between value and growth is now larger than at any point over the past six decades, with one exception—the top of the dot-com bubble.” Barrons, June 28, 2017
The letter is a great read and is well worth your time. The letter makes two very key points:
Value stocks are going through the longest cycle since World War II of underperformance versus growth. Each period of time that growth outperforms value, value eventually stages a significant resurgence. Their chart showing this history can be accessed here.
They also have a great analysis of the performance of different valuation metrics since 1970. They find that using enterprise values instead of raw market prices in a valuation ratio works best. They find that all of the major valuations work and, as is demonstrated in Deep Value, the acquirer’s multiple (in both the EBIT and EBITDA variations) exhibit the highest performance. The comparison of different valuation metrics can be accessed here.
Conclusion
I don’t know when or how the current cycle will shake out. I am confident in one thing: buying expensive stocks is dangerous and buying cheap stocks is a safe long term bet, no matter how you slice it. The current disconnect will not last forever.
I think indexing makes sense over the long run and I don’t think we’re on the brink of a 1929 or 2008 scenario. With that said, I do think that this current environment is fueled by performance chasing, just as it was in the 1990s. Just like the 1990s, money is pouring into large cap index funds. As index funds concentrate their bets on the biggest components of the index, those companies see their valuations increase. This isn’t due to any change in their actual business performance but is due to their weighting in the index. The money pouring into index funds is not permanent capital and I suspect many will head for the hills once the current cycle turns on them, as usually happens.
Most investment strategies work and make no mistake: indexing is simply a strategy. It’s a smart, tax efficient and cheap strategy. It will only work for investors if they stick to it, which they typically don’t, as demonstrated by this chart.
Value is having a tough time, but it’s times like this that are the reason value investing works over the long run. If value investing delivered double digit returns every year consistently, then everybody would do it.
The strategy I am pursuing is consistent with Ben Graham’s recommended strategy from the 1970s: buying low P/E stocks that have safe balance sheets. I look at other factors (such as the enterprise multiple), but that’s the gist of what I’m doing. When looking at my own performance, I compare it to this backtest of the strategy done over at Alpha Architect. In 1998, the 20-stock variation of the strategy lost 9.01%, compared to a 26% gain in the S&P 500. In 1999, the strategy gained 4.55% against a gain of 19.53% in the S&P.
The worst year for the strategy was 1969, in which it lost 28%. The S&P lost only 8% that year.
Over the long run, however, Ben’s simple (but not easy) strategy delivered a 15% rate of return. That’s the long run return I’m striving for with this IRA over the next few decades.
I don’t know how long the doldrums will last, but I do know they will end. It may take years, but I’m not going to abandon it. The only thing I may change if the market takes a hit is to shift my focus to asset-based investing (i.e., net nets and stocks below tangible book). The only reason I’m not doing that now is that they are not available in sufficient quantities.
“Deep Value” by Tobias Carlisle is one of my favorite books. I have a brief review in the books section of this website, but I think it is worthy of a more in depth review. The price of the book is expensive, but it is well worth it!
Mr. Market is Crazy
For years, I’ve believed that value investing works. It makes sense to me intuitively. It’s better to buy something cheap than something that’s expensive. I’ve read The Intelligent Investor, Security Analysis and all of Joel Greenblatt’s books and internalized the lessons. It just makes sense to me to buy earnings and assets for as little as possible.
It also makes sense to me that markets are fallible. I spent my high school years (I graduated high school in 2000) fascinated with a seemingly unstoppable market. I was only a teenager, but it seemed crazy to me that companies producing no earnings could command such high valuations. I remember thinking at the time: “It makes no sense, but these people know more than I do about the subject.” It turns out that they didn’t. An army of market prognosticators with extensive experience and impressive academic credentials were no smarter than me, a 17-year-old kid who hadn’t even gone to college yet.
I went through a similar experience during the real estate bubble. When I looked at charts of real estate prices, I once again instinctively thought that it was insane. Homes were increasing by 30% a year when incomes were stagnant and the raw materials to build the homes weren’t going up. It made no sense. Once again, I turned to the experts. Few were raising any alarms or taking the problem seriously. Surely, a financial bubble couldn’t form in an asset as illiquid and solid as real estate. I assumed that the experts must be right and I must be missing something. After all, they were more knowledgeable than I was. Then, along came 2008.
In 2008 during the crash, I kept thinking back to Benjamin Graham’s description of Mr. Market that I read about in The Intelligent Investor. Ben Graham was right. The stuff I learned in college about efficient markets couldn’t be true. Mr. Market is crazy and Ben Graham was right all along.
Why does it work?
While I believed that value investing works and this was confirmed by my observations, I never understood why it worked. It makes sense that buying dollar bills for 50 cents will work out in the long run, but how is this value realized?
Ben Graham was actually asked this question by Congress in the following exchange:
Chairman J. William Fulbright: What causes a cheap stock to find its value?
Benjamin Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else.
This is the key question that “Deep Value” delves into, through an analysis of data and real world examples.
Mean Reversion
The most powerful force through which value is realized is mean reversion. I always thought of mean reversion in the sense of a stock chart, a price will revert to the mean.
What Tobias explains is that mean reversion applies less to stock charts and more to the actual performance of a business. Tobias explains, for instance, that the biggest earnings gainers of the next few years are typically the worst performing businesses. Other similar studies are brought up in the describing this tendency of businesses to change course.
Poorly performing businesses are trying to turn things around. They are not resting on their laurels. Meanwhile, changes are typically occurring in their industries that are improving things for the better.
I think it’s easiest to think of this phenomenon in terms of chemical companies and basic economics. Chemical companies can all produce the same thing. They all have the same resources. If a chemical runs up in price, all of the chemical companies are going to make more of it. At this point, all of the chemical companies are doing great and their stocks are likely to be bid up to high valuations. Eventually, the chemical will be over-produced and it will drop in price. All of the chemical companies will drop to low valuations. This situation sets the stage for the recovery. The chemical companies will inevitably scale back production. Some companies may go out of business, which will further reduce supply. The reduction in supply will eventually spur an increase in the price, which will ultimately lead to a recovery in the chemical business.
Meanwhile, news stories will be written about what a terrible business it is to produce this chemical, causing this wisdom to seep into the minds of investors. There then exists a situation where chemical companies can be purchased at a discount at a nadir in the business that is about to turn around.
The situation is doubly lucrative: a cheap stock at a point in the business cycle where it is about to turn around.
The lesson here is that human beings tend to think that the future will unfold like the past. Trends that are in place today will go on forever. This is rarely the case and it is one that Tobias demonstrates through a careful analysis of the data.
Mean reversion in business is the main force driving the realization of value.
The Illusion of “Quality”
Prior to reading deep value, I always assumed that the best course for the value investor was to combine “cheap” with “quality”. Yes, there are cheap ugly stocks out there, but many of them are dreaded “value traps”. Meanwhile, careful analysis can lead an astute investor to value investing gems: cheap companies that don’t have any real problems, companies that are growing and generating attractive returns on capital.
Tobias reveals that adding elements such as growth or high returns on capital to a value model actually underperforms cheap by itself. The ugliest value stocks are frequently the ones that lead to the highest future outperformance. This makes sense: if something is truly cheap, there must be a reason for it, and the scarier the reason then the better the bargain an investor will get. Moreover, the uglier the stock, the more likely its prospects for mean reversion.
This lesson is reinforced throughout the book with real world examples and massive quantities of data.
The Acquirer’s Multiple
Tobias’s preferred metric of “cheapness” is Operating Income/Enterprise Value (or other variants, such as EBIT/EV or EBITDA/EV). He provides data showing this metric’s historic outperformance. I found the same thing in my own backtesting, and O’Shaughnessy also verifies this in his most recent edition of What Works on Wall Street in which EBITDA/EV is given a prominent chapter.
The multiple works because it identifies stocks that are not only cheap but have healthy balance sheets. The balance sheet health allows them to survive whatever problems that the business (or industry) is enduring.
Another reason it works is that the metric is most often used by acquirers such as private equity firms.
What is Deep Value?
Another goal of this book is explaining how “deep value” is distinct from other types of value investing.
Most associate value investing with the investing style of Warren Buffett. Buffett began his career buying what he derisively called “cigar butts”, or simple cheap stocks. They were cigar butts in the sense that you could pick them up off the street for free because they were so cheap, and enjoy one last puff.
Buffett moved on from this style for a few reasons. The first was the influence of Charlie Munger, who was less influenced by Graham and was more interested in buying quality businesses.
The second was scale. Buffett became too big to nimbly buy a cheap low capitalization cigar butt, take his free puff, and move on. Frequently, Buffett had to buy up such large quantities of cigar butts where he became mired in the operational struggle.
The second was a handful of experiences that pushed Buffett in the direction of greater quality investments. In investments such as Dempster Mill (a struggling manufacturer of farm equipment) and Hochschild Kohn (a retailer forced to compete at razor thin margins in Baltimore), Buffett had to take controlling influence in each company to turn them around. In both situations, controlling a struggling company took its toll and consumed significant time from Buffett.
The experiences with Dempster and Hochschild stood in contrast to a different kind of investment that Buffett made in the 1970s: See’s Candy. See’s was a good business with a great brand. It generated high returns on capital and required little meddling. Once Buffett bought See’s and saw the benefits of high returns on capital, there was no turning back, and this became the basis for his future investment style. From then on, he bought large stakes in companies generating high returns on capital and held onto them for long periods of time to let them compound.
The 1970s and onward style of Buffett’s investing career is what most people think of when they hear “value investing”. Deep value, in contrast, is the style of investing that Warren Buffett used earlier in his career when he was managing smaller sums of capital and generated higher rates of return. Deep value is the style originally advocated by Benjamin Graham and later applied by investors such as Walter Schloss.
Deep value is buying cheap for the sake of being cheap and allowing mean reversion to return the stock to its intrinsic value.
The Buffett style of investing is certainly preferable because it generates higher compounded returns for longer periods of time, but it is extremely difficult to find businesses that generate high returns on capital that will not succumb to the forces of mean reversion. It is also a crowded trade, as all value investors are attempting to marry quality with cheapness.
Practical Application
Tobias maintains an excellent free stock screener keeping track of the best-ranking stocks according to the acquirer’s multiple, which you can use to systematically implement a value investing strategy. The large cap version is free, he also offers a paid version for the all-cap universe.
Recommendation
It’s rare that a book comes along that changes my mind and makes me see things from a different perspective. “Deep Value” was one of those books. I’ve read it three times so far and each time I gain a greater insight into the ideas that it conveys. I can’t give it a higher recommendation.
One of the common responses I hear when I tell people that I buy and sell stocks using my own analysis goes something like this:
“Why even bother? There are so many smart people researching these stocks with far more time to devote to it than you. They have better information and can do more homework. You might as well buy an index fund.”
Indeed, there are many people trying to beat the market and Wall Street spends a vast amount of money on research and analysis, which is likely superior to the analysis that I have the time to do.
The Data
I decided to step back and check the actual data about Wall Street recommendations. I wondered what would happen if you systematically bought baskets of each Wall Street recommendation (buy, sell, etc.), held on to them for a year and then re-balanced annually. The results from the Russell 3000 universe are below:
If Wall Street analysis were on point, there would be a more linear result. Each basket should outperform the next.
Instead, the actual data produces this choppy result. Neutral ratings outperform buys and strong buys. Meanwhile, those rare “strong sell” ratings actually outperform the sell recommendations.
This analysis of Morningstar star ratings comes to a similar conclusion. Morningstar assigns star ratings to mutual funds (5 stars are the best, 1 star is the worst). The paper linked to analyzes the resulting returns after Morningstar issues the rating. The 5 star ratings outperform the 1 star ratings, but in the lower end it gets lumpy. The 1 star rated funds outperform the 2 and 3 star funds.
Also, consider this tidbit of stock market history which is quite shocking: in November of 2001, more than half of Wall Street analysts rated Enron as a buy or better.
Why This Result?
This leaves one to speculate: why do we get this result? I think there are three key reasons:
1. Human nature makes us extrapolate the present into the future. Analysts aren’t immune to this tendency.
Any analyst can look at Amazon, for instance, and tell me that they are doing a great job at growing their revenues. Any analyst can look at the retail sector and tell me that retail is hurting as more consumers shift their buying preferences online. In 2006, any analyst could tell you that the financial sector was enjoying a nice upswing and would also provide you with a very convincing explanation (i.e., the “financial supermarkets” created in the wake of Gramm-Leach-Biley were leading to higher returns on equity for banks) or that the energy sector was doing well thanks to advancing oil prices (they would probably say that oil would continue to increase due to growing demand from emerging market economies and peak oil). In 1999, any analyst could have looked at the growth in fiber-optics and told you that JDS Uniphase was doing very well and would continue to do so because the rapidly growing information economy would fuel greater demand for fiber optic cable. Analysts are frequently deceived because they underestimate the tendency of things to change. Some have expressed this sentiment with greater eloquence.
When you look at a Wall Street research recommendation, what you’re seeing is the conventional wisdom. The conventional wisdom is usually an extrapolation of what is going on right now into the future. The conventional wisdom usually becomes more ingrained when we listen to really smart people provide convincing explanations for why the trend will continue.
Things change and the conventional wisdom is frequently incorrect. It is human nature to take trends and extrapolate them into the future. This worked for our ancestors trying to evade a predator, but it doesn’t work when trying to predict changes in the modern world. The tendency of trends to reverse (for great businesses to falter, for bad businesses to turn around) defies the ingrained expectations of human nature.
2. Wall Street doesn’t care about valuation as much as it should.
Valuation plays another role. Stocks with “strong buy” recommendations are frequently overvalued. Of the 32 analysts covering Amazon, for instance, 23 of them have a strong buy recommendation. Clearly, valuation isn’t even considered the analysis, as Amazon currently has a P/E ratio of 179.84. Amazon might continue it’s ascendancy, but history shows that stocks with such lofty valuations frequently under-perform. Amazon’s business may continue to succeed, but that doesn’t mean that the stock is a good investment when the lofty valuation is taken into consideration.
3. Wall Street prizes access to management.
Wall Street values good relationships with companies. Sell ratings or critical analysis hurts the relationship that banks have with companies. As this Bloomberg article explains, relationships are the reason that only 6% of the 11,000 Wall Street recommendations are sell ratings.
Relationships are critical to Wall Street. A good relationship with a company means that the Wall Street banks are more likely to underwrite deals for those companies, such as mergers and acquisitions, which generate high fees for the banks. Good relationships can also improve their odds in being selected to underwrite new loans for that company, another important source of income.
Another reason is that they want access to management to get better information about the companies. They feel that access to management is a critical component of gathering information about potential investments.
My unconventional view is that talking to management can be counterproductive. Management is always going to say things that are positive about the company no matter what, so what’s the point of even entertaining them? CEOs typically get their jobs not because of any technical expertise, but because they are masters at dealing with people. They are typically wildly charismatic people.
Charisma is usually not matched off with any real expertise or insight. When Wall Street analysts talk to management, they are simply being charmed by a charismatic person into believing a more optimistic portrayal of the company than is actually deserved. I think an investor is better off going to sec.gov and reading through the financial data published in quarterly and annual reports rather than allowing themselves to be manipulated by a charismatic management team.
The great Walter Schloss had this to say about meeting with management: “When I buy a stock, I never visit or talk to management because I think that a company’s financial figures are good enough to tell the story. Besides, management always says something good about the company, which may affect my judgment.”
Conclusion
My conclusion is simple: small time investors can win at this game even though we are at an informational disadvantage. This is because much of the Wall Street “analysis” is clouded by behavioral biases, an under-appreciation for value and a tendency to be manipulated by management.
A small investor can also operate in corners of the market where Wall Street banks fail to look, as their focus is usually on extremely large companies that can generate fee income.
Moreover, as has been discussed previously on this blog, Wall Street is increasingly short term oriented. In a world where investors obsess over their returns on shorter and shorter time periods, an investor with a long term outlook and willingness to under-perform in the short run is at a significant behavioral advantage.
I’ll end this with a quote on this subject from the master himself, Benjamin Graham:
“The typical investor has a great advantage over the large institutions . . . Chiefly because these institutions have a relatively small field of common stocks to choose from–say 300 to 400 huge corporations–and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list–say, 30 issues or more–that offer attractive buying opportunities.”
I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.
