During the past several months, some prominent Wall Street players have questioned the enduring legacy of value investing or have outright declared its imminent death. And why not as we are enjoying a bull market for the ages where non-dividend paying growth stocks (FANGs), momentum trading, trend following, and high yield dividend equity (HYDiS) among other speculative portfolio strategies, are outperforming the more risk averse value approach.
But we think that investing in quality, dividend-paying companies at reasonable prices — whether from a growth or value perspective — endures well beyond the scrap heap where this market may ultimately dump the portfolios of investors that are chasing fast money in the euphoria of a post-Great Recession boom.
Thus, we believe value investing will survive as the superior investing strategy along with dividend growth investing not called HYDiS. Value investing is not dead. It is just camouflaged, with die-hard practitioners waiting in the bushes ready to pounce on the falling stock prices of otherwise enduring enterprises.
Here is Main Street Value Investor’s argument that value matters in all markets.
From Bust to Boom
American writer and humorist Mark Twain (C. Stovall for Pixabay)
Remember the junk bond-fueled 80’s that led to the 1987 stock market crash? How about the dot-com craze of the late 1990’s that ended with the tech crash and subsequent bear market at the turn of this century? Perhaps we are all young enough to recall the housing boom that led to the capitulation of the stock market in 2008 and the ensuing Great Recession, the worse economic downturn since the Great Depression of the 1930’s.
If Benjamin Graham, the father of value investing, and Mark Twain, the legendary writer and humorist spoke from their graves with words of wisdom on today’s bull market, Graham would be screaming “where’s the margin of safety” as Twain reminds us that history does not necessarily repeat but certainly rhymes.
Well, high yield junk equity rhymes with high yield junk bonds, expensive internet growth stocks rhyme with dot-coms, central bank quantitative easing rhymes with savings and loan deregulation, and forever ascending stock prices rhyme with perpetually climbing home prices.
Trends are just that, trends which, by definition, always come to an end.
Nobody knows precisely when, but this end cycle will leave a secondary, more palatable heap of quality enterprises on sale for a limited time with a wide margin of safety or discount to perceived intrinsic value.
Grantham On Investors’ Preference for Extreme Comfort
Jeremy Grantham, the famed deep value co-founder of the Boston-based investment firm, Grantham, Mayo, & van Otterloo [GMO] started the latest debate on the virtues of value investing in GMO’s Q2 2017 letter to shareholders. Grantham’s argument was not about predicting the death of value investing as much as a narrative on why current stock market prices are trading beyond a reasonable margin of safety.
Investors’ extreme preference for comfort, like human nature, has never changed (tested back to 1925.) This is unlike financial and economic conditions, which have very substantially changed in the last 20 years.
The ebb and flow of these variables explain previous market peaks and troughs. These comfort factors, for example, have been at an extremely high average level for 20 years (as have P/Es) and remain so today. Thus today’s high priced market is the completely usual response from investors.
Any shift back to a lower P/E regime must therefore be accompanied by a major sustained fall in margins or a sustained rise in inflation (or both).
And, yes, I do believe these comfort variables will move to be less favorable. But probably not quickly.
Grantham correctly called and positioned his portfolios for the dot-com and housing bubbles, but has seen a negative outflow of GMO funds from clients as his bearish view of the current bull market is challenged daily by ever-rising indices.
Nonetheless, we believe that neither GMO clients’ performance chasing nor Grantham’s penchant for predicting market crashes is a sustainable investment strategy.
On a long enough timeline the survival rate for everyone drops to zero.
-Chuck Palahniuk from his best-selling satirical novel and movie, Fight Club
We agree with investment site, Zero Hedge that Fight Club’s sarcastic, although eerily truthful anthem also applies to the markets. As such, life expectancy, whether human or markets, is mostly unpredictable in the context of exact time frames.
Goldman Sachs: there isn’t much value in investing these days
At about the same time as Grantham’s narrative, Wall Street staple Goldman Sachs Group (GS), in a widely-covered report, argued that buying stocks with the lowest valuations and selling those with highest is not working in this bull market. According to Goldman, the pure play value strategy, known as Fama-French, has resulted in a cumulative loss of 15% over the last decade following a 70-year cumulative positive return for the same investment approach. We argue that investing solely on value is as speculative as trading non-dividend growth FANGs, i.e., Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google parent, Alphabet (GOOG) (GOOGL), among others. As is an over-reliance on HYDiS to leverage a retirement portfolio (read my article: High Yield Dividend Stocks Are Equity Junk Bonds); or the reemerging craze of trend following to quench an insatiable investor thirst for fast money.
At Main Street Value Investor (MSVI), we define value investing as a commitment to both price and quality. Our investment objective:
Buy and hold U.S. exchange-traded, dividend-paying, well managed, financially sound businesses, or funds of companies that produce easy to understand products or services, have enduring competitive advantages from wide economic moats, enjoy steady free cash flow, and are trading at a discount to our perceived intrinsic value at the time of purchase. Then, of utmost importance and perhaps the biggest challenge, practice patience in waiting for our investment thesis to play out as projected over a long-term horizon.
MSVI’s investment objective enthusiastically follows the rational wisdom of legendary value investor, Warren Buffett. As reiterated in the excellent HBO documentary, Becoming Warren Buffett, he endured a transformation from buying cheap companies, regardless of quality, and unlocking value through corporate events, i.e., dump the stock when the price increased to a profitable level; to buying and holding wonderful companies at fair prices and taking advantage of the magic of compounding.
Buffett acknowledges that it was under the tutelage of his partner Charlie Munger that he made this career makeover from a stock trader to a company investor.
As influenced by Buffett and Munger, we prefer investing in quality, enduring companies as opposed to trading in speculative, faceless stocks.
David Einhorn: FANGs are killing value investing
Another household name from Wall Street, famed long and short value investor and founder of hedge fund Greenlight Capital, David Einhorn, thinks the popularity of non-dividend paying, ultra-growth FANG stocks, are redefining how shares are valued. In October, Einhorn wrote the following passage in an investment letter to Greenlight clients:
Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value.
We think Einhorn’s banter is relevant in the current trend of ever-rising stock prices without regard to valuation multiples and underlying fundamentals. But we also believe that his presumption of the death of value investing as we know it is a trend in of itself.
Such a vogue paradigm will likely fade as most trends do, and the argument will revert to the mean that all things bought and sold are valued based on the correlation between quality and price. This fundamental economic reality may vary in reasonable or unreasonable ways but will never change because theoretically, valuation cannot deviate from the buyer and seller’s independent perceptions of the actual price relative to perceived worth.
Perhaps a return to the basic tenets of value investing is in order.
Value Investing 101
Value investing is a simple strategy in an otherwise superfluously complex financial services industry.
At Main Street Value Investor, our definition of value investing is steadfast to the word value as it applies to all aspects of our consuming lives, including investments.
“Value” as defined by Miriam-Webster:
Amount of money that something is worth.
Price or cost of something.
Something that can be bought for a low or fair price.
Usefulness or importance of something.
Our research and analysis of stocks and funds are quite similar to the purchase considerations in other aspects of our lives:
What is the product or service worth to us? What is the quoted price? What is the difference and will it be available for a lower or fairer price at some point in the future? Put another way, is it mispriced based on the inherent value we place on the product or service? And, just as important, why buy an attractively priced product or service unless we see usefulness or importance in owning the product or service?
Now substitute “stock and fund investment” for “product or service” and re-read the same paragraph based on our formal definition of value:
What is the company or fund of businesses worth to us? What is the quoted price? What is the difference and will it be available for a lower or fairer price at some point in the future? Put another way, is it mispriced based on the inherent worth we place on the company or fund? And, just as important, why buy an attractively priced stock or fund unless we see usefulness or importance in owning a slice of the business or fund?
Next, we apply the above formal definition of value to our investment philosophy repeated for reader convenience.
Investment Objective: Buy and hold U.S. exchange-traded, dividend-paying, well managed, financially sound businesses, or funds of companies that produce easy to understand products or services, have enduring competitive advantages from wide economic moats, enjoy steady free cash flow, and are trading at a discount to our perceived intrinsic value at the time of purchase. Then, of utmost importance and perhaps the biggest challenge, practice patience in waiting for our investment thesis to play out as projected over a long-term horizon.
The above mission statement or investment philosophy is short, to the point, and focused on quality products and services with built-in barriers to competition that are produced and sold by financially sound companies or funds of those companies. The representative securities are purchased at fair, reasonable, or cheap prices, and held for as long as our conviction remains intact or improves as demonstrated by the overall performance of the company stock or stock fund.
So how do we measure the quality of a company’s product or services, its competitive advantages, financial strength, and intrinsic value or perceived enduring value relative to current price?
First, we give our portfolio a K.I.S.S., i.e., Keep Investing Super Simple, by limiting our measurement and analysis to a handful of essential metrics in each key area of the company or fund. Our due diligence involves profile, value proposition, fundamentals, valuation, and margin of safety; with a counter understanding and acceptance of the downside risk, should our thesis or perception of intrinsic value misfire.
Modern methods of measurement utilized by momentum investors and day traders such as technical analysis, or the in-depth study of past price behavior, are avoided.
The legendary value investor, money manager, and author, Howard Marks, writes in his must-read book, The Most Important Thing (New York: Columbia University Press, 2011):
Moving away from Ouija boards, along with all other forms of investing that eschew intelligent analysis, we are left with two approaches, both driven by fundamentals: value investing and growth investing.
As does Howard Marks, we focus on value investing in our fundamentals driven analysis of equities.
In essence, we research the company and then tell a story of why or why not the stock is worthy of ownership. Intelligent investors own risk-averse slices of wonderful companies. We leave the trading of stocks to risk-defying speculators.
Instead, the MSVI model portfolio invests in companies producing worthwhile and profitable products or services that assist consumers worldwide in solving personal and business problems, wants, or needs. The portfolio represents a collection of owned slices of companies producing high quality, in-demand products and services with enduring competitive advantages.
We leave the crystal ball to market speculators as ours cracked years ago.
Trying to Predict Market Events is a Fool’s Game
Value investors buy financially stable companies with strong fundamentals when macroeconomic events produce attractive valuations. Then sell or reduce the holding on weaker fundamentals or inflated valuations when microeconomic events erode the company’s financial strength or the demand for its products and services.
In his bestselling nonfiction book, The Black Swan: The Impact of the Highly Improbable (New York: Random House, 2007), Nassim Nicholas Taleb presents his black swan theory or the extreme impact from certain kinds of rare and unpredictable events or outliers. He explores the human tendency to find simplistic explanations for the occurrence in retrospect. This rationalization is in spite of the individual or group taking a beating as a result of the surprise episode.
From an investment perspective, the timing of the book was profound as the Black Swan event that became known as the sub-prime mortgage crisis that led to the Great Recession occurred one year after the publishing of Taleb’s book.
However, Taleb writes that he does not attempt to predict Black Swan events. To the contrary, he proposes that being aptly prepared for these surprise macro events, should one occur, is more prudent than attempting to forecast the anomaly. He illustrates by suggesting a Black Swan event is a “surprise for the turkey but not the butcher.”
An obvious translation of his theory is the typical Wall Street philosophy of trying to predict market fluctuations, i.e., the market timer as the turkey, versus manipulating the market’s ebb and flow to your advantage after they unexpectedly occur, i.e., the value investor as the butcher.
If the Wall Street market timer is wrong in predicting a Black Swan event, granted incorrectness is often the more likely outcome, he or she may lose substantial assets from being too long or too short.
On the other side of the trade, the value investor is already prepared to take advantage of any surprise Black Swan macroeconomic event by allocating planned cash reserves to take new or increased positions in the stocks or funds of fundamentally strong companies. He or she takes advantage of indiscriminately depressed prices from the macro event. These incidents, any tragedies notwithstanding, are the value investor’s white swan.
For example, investors that held, added, or initiated quality positions immediately following the market crash of 1987, during the dot-com bear market of 2000-2002, or in the early run-up after the Great Recession of 2007-08 invariably profited from subsequent booming portfolios.
To be sure, a few lucky speculators predicted these events and perhaps benefited from them, but many investors reacted after the fact by foolishly selling-off already depressed securities. I imagine more than a few of these Black Swan victimized portfolios have yet to recover.
I have observed that investors who successfully predict a Black Swan event often become intoxicated by the lucky call and begin to base his or her investing philosophy on the sudden perceived ability to predict future events. Such inebriation of financial intellect induces proverbial gazing into the crystal ball that magically filters a false state of being. What is predictable is that the luck soon runs out as does the principal on his or her investments.
Unless, of course, you have the seemingly magical instincts of Warren Buffett.
Fear and Greed are Pricing Mechanisms for Value Investors
Warren Buffett (Reuters)
The value investment theory of buy when the Black Swan flies, a surprise event affecting an entire economy or sector; and sell when the swan comes home to roost, a surprise event affecting only a company or industry also appears in a metaphor from the most famous value investor of all time.
I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful. -Warren Buffett
What Nassim Taleb wrote so eloquently in a 400-page book, Buffett independently coined in a brief passage. The lessons of Howard Marks, Taleb, and Buffett for value investors are to stop market timing or stock trading and start investing or divesting as actual macro and microeconomic conditions dictate. In most cases, that means being contradictory to the crowd.
As such, the value investor sticks to the tried and true approach of researching a company’s fundamentals to determine the level of ownership worthiness; then, if warranted, measures the stock’s valuation multiples to decide whether to buy, add, maintain, reduce, or sell the holding.
Value investors are steadfastly patient in waiting for Taleb’s random Black Swan macroeconomic event, or Buffett’s fearful retreat from stocks on Wall Street. As prices drop to attractive valuations, we will sift our watchlist for superb, fundamentally sound companies trading at appealing valuations that offer what we perceive as reasonable margins of safety.
Alternatively, we may just add to our current positions, as our first, seventh, and twelve ideas are probably better values than the 20th opportunity presented by the Mr. Market.
And whenever the swan comes home to roost, and Wall Street traders get greedy, thereby negatively affecting the fundamentals, valuation, or margin of safety of a single holding, we will consider reducing or eliminating our ownership in that position. Conversely, if trader reaction to the micro event renders attractive valuations with wide margins of safety, we will purchase a new stake or add to the position.
Another reminder that value investors are contrarian by nature.
Is There Further Downside to Value in this Bull Market?
The inherent risk to the value investing model is the non-value investors that permeate this and most market cycles.
Chasing the dragon has been a cornerstone of investing for Wall Street professionals and Main Street do-it-yourselfers since, well, market trading began. Human nature dictates that once we outsmart Mr. Market and successfully predict this swing or that trend, or go beautifully long or short on a stock or sector, it is “off to the races” as they say at the horse track. We begin the hamster roll of predicting and trading with abandon because we are self-convinced that we have this thing figured out.
As validation, there is always a perceived reputable assist to our sudden crystal ball accuracy. Lately, that has been in the form of the current U.S. president — who despite claiming he is not invested in the stock market, although apparently he is — takes credit for igniting it to its present record levels as well as fueling speculation of more upside from deregulation, trade renegotiation, and tax reform.
Of course, before November 2016, there was an assist from the Federal Reserve in keeping interests rates artificially low. Before that the hand-off came from government deregulation of the housing market allowing most anyone to buy a home and for unscrupulous investment banks to package the mortgages into marketable securities, thus creating more mortgage dollars.
Before the highly rated — despite no doc and no income — mortgages, there was an assist from the capital markets of free-flowing investment into dot-com ideas that were just that, ideas. And before that, there was the contribution from junk bonds that creatively financed otherwise impossible mergers and acquisitions.
Yes, the most significant threat to a value investor is the market itself. But Mr. Market is also our friend as he can be counted on to deliver individual company or entire market value opportunities. Dedicated value investors stay self-disciplined and patient as we do not know when or how those opportunities will present themselves. Nevertheless, make an appearance they will and when least expected.
We prepare for the pending downside with dry powder in the form of FDIC-insured cash to ride the ensuing upside in the stocks of quality companies that are temporarily value-priced by the sudden extreme preference for discomfort among investors.
Because as value investors, the market or targeted company’s downturn is our workday while the upturn is our payday.
Jeremy Grantham’s note to clients on the extreme preference for comfort by the market’s likely future victims, aka the perma bulls and market timers, reminds us that the day of reckoning is inevitable, although not pinpoint predictable.
Instead of chasing the dragon, value investors prefer the long-term benefit of partnering with a company that supports its customers with in-demand, useful products or services, rewards its employees with sustainable career opportunities, and compensates its shareholders with positive returns protected by world-class internal financial controls.
As individual value investors, we never stress over failed short positions, diminishing assets under management from departing performance chasers, or useless self-doubt fueled by the 20/20 hindsight of missing out on the FANGs and HYDiS when they were trending upwards. We remind ourselves that for every speculative winner, there are several Enrons, Blockbusters, and Valeants (VRX).
Ultimately, we take extreme comfort in knowing that as long as there are financial markets or farmers markets, value investing will prevail.
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Comments are strongly encouraged and always welcomed. Please read the important accompanying disclosures.
Main Street Value Investor is a trademark, and Main Street Value Investor Model Portfolio (MSVI) and Main Street 20 Watchlist are service marks of David J. Waldron.
Data Sources: Seeking Alpha, Goldman Sachs, and YCharts.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Data is for illustrative purposes only. The accuracy of the data cannot be guaranteed. Narrative and analytics are impersonal, i.e., not tailored to individual needs or intended for portfolio construction beyond the contributor’s model portfolio which is presented solely for educational purposes. David J. Waldron is an individual investor and author, not an investment adviser. Readers should always engage in further research and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or qualified attorney before making any investment, income tax, or estate planning decisions.