Myths and Misconceptions
November 30, 2018
Randall Abramson, CFA
President & CEO,
This article has been excerpted and edited from our quarterly newsletter to clients dated September 20, 2017.
VALUE VS. UNDERVALUED
We don't buy value stocks per se. We buy undervalued stocks. There’s a difference. Value stocks are generally understood to be those that trade at low multiples of earnings or book value. And many investors practice their trade by purchasing what they believe to be cheap stocks by finding those that are trading at relatively lower multiples than the market or industry peers. We prefer a stricter approach, analyzing companies and arriving at appraisals of fair value such that we have an absolute (as opposed to relative) view of the company’s price with respect to our fair value estimate. We believe this approach offers a better margin of safety and provides us with the ability to have appropriate targets—fair market values (FMVs) where we look to exit positions. Most stocks trade between undervaluation and fair value. Once fair value is achieved, the best one can hope for is to track a company’s growth rate but the stock becomes more susceptible to a downturn from any overall change in the expected growth rate or other factors impacting its value.
GROWTH VS. VALUE
Observers also like to distinguish between growth and value stocks. Generally, growth stocks are those that trade at high multiples and whose earnings are expected to grow at a fast clip, whereas the opposite view is held for value stocks. Again, here, we have a different opinion. Most of the time, a company must be growing, and at a decent pace, to justify it being good value—though a company can have flat or declining earnings and still be undervalued, if its price is too far below the expected future free cash flows of the business. However, normally it’s a value trap—a company that appears undervalued but whose fundamentals are deteriorating, in turn eroding fair market value along with its share price. We seek to own companies whose FMVs are growing up and to the right—companies whose earnings are ever-advancing but for various reasons, usually a recent setback, the share price has declined or remained flat while our view of underlying FMV remains higher.
While this may sound academic (i.e., too technical), it’s an important distinction. It has led us to focus on the type of securities we prefer to own. Research over many years has shown that owning value stocks over growth stocks leads to market-beating results. We have always embraced that research. However, we try to focus on companies that aren’t just undervalued but also have steady earnings growth rates, generally higher quality businesses that are strong operationally and financially, in an effort to also mitigate losses.
FULLY INVESTED VS. HEDGE
It’s generally believed that one should be fully invested at all times. The reasoning is simple. If stocks are the highest returning asset class and if market downturns are difficult to predict—there’s always some prognosticator calling for doom and gloom—then one should ignore the noise and remain “in it to win it.” Here too we differ. In spirit we agree—one should be fully invested most of the time—because over two-thirds of the time we are in a bull market. If, on the other hand, one could forecast the timing of the other third—the bear market—one could avoid the drawdowns. Something business schools teach can’t be done—to have our cake and eat it too.
We don’t like drawdowns and our clients detest them. And, simply put, when FMVs are falling, so are share prices. When are most company values declining? In a recession. So we developed an Economic Composite to alert us to recessions both in the U.S. and abroad. Similarly, we developed a market momentum indicator (TRIM™) to alert us to bear markets—those that decline by more than 20%. And, in periods when our alerts aren’t triggering, like today, we should have even more confidence to be fully invested. Though, one key caveat now, we still need to be able to find enough investment opportunities that meet our criteria—currently not an easy task. In our large cap only portfolios we have held an outsized cash position which has restrained our returns. Not because we have been bearish, but for lack of our ability to find enough attractive opportunities, not for lack of looking.
PASSIVE VS. ACTIVE
At the bottom of the market, passive investing can make a lot of sense. When bargains abound it can pay to invest broadly—to have exposure to everything and limit the risk of a few holdings preventing outsized returns. However, when valuations are full, or markets are overpriced, then caveat emptor (buyer beware) as broad exposure can be riskier than holding a better mix of undervalued stocks.
Because the markets are fully valued and growth rates are low, the U.S. market is exhibiting the lowest prospect of long-term returns in years. The Value Line appreciation potential index, which has been remarkably accurate over the years, is forecasting a 5-year return of only about 6% per year—in the bottom decile since the late '60s. And a 60/40 asset mix (60% S&P 500 stocks, 40% U.S. 10-year bonds) which before fees has returned 8% per year since 1880, half of which came from bond yields, looks like wishful thinking today given a 2% government bond yield, a fully-priced stock market and the lowest economic recovery rate of the last several economic cycles.