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Is the Stage Set for Value Investing to Outperform?

 

Tuesday, July 18th, 2017


Over the past year I have been discussing how the average investor has only received annualized investment returns of 2.1% over the last 20 years. Unfortunately, investors continue to make the wrong decisions as they chase past performance and do not focus on the future potential and the value of what they pay for an investment. 
 
A prime example is the current influx in ETF's, which has experienced seven consecutive months with more than $20 billion of inflows. Considering past performance and low fees, many investors have high praise for ETFs. The problem is many investors do not understand they are self-fulfilling and the more money which goes into them, the more they will rise, that is until the music stops and once again investors will experience losing returns as markets fall.
 
So, what is an investor to do? Sell everything and go to cash and money markets? The answer is definitely not. Investors also get confused, believing that when the stock market goes down all stocks go down. This is not true for value stocks. In a recent University of Chicago study going back to 1926 value beat growth by an annualized average return of 4.8%. However, since 2005 growth has beat value every year, but only by an annualized average of 0.7%.
 
Amateur and professional investors are beginning to throw in the towel and switch from value investing to growth investing at most likely the worst possible time. This is not the first time this has happened since 1926, it has happened numerous times before with the most recent period ending March 2000. That was the month the dot com bubble burst. 
 
In the following few years, value investing far outpaced growth investing and not by a small margin. For the following 31 months after the dot com bubble bursting, value outperformed growth by an annualized return of 32%. That is huge!
 
What this should alert investors to is the crazier things get the better value investing will do moving forward. With companies like Amazon, Netflix and Tesla (just to name a few, even companies like Home Depot are way over valued) trading at nose bleed levels, I do not know how much crazier things can get. If they do continue to move higher the decline will be that much greater and the value performance would be even higher than it was in the months and years which followed the March 2000 bursting of the bubble.
 
Kent Daniel, a finance professor at Columbia University points out the spread between growth and value, except for the dot com bubble, has not been this large in 60 years. In other words, the lack of popularity in value stocks makes them a far better investment relative to growth going forward. Statistically, Professor Daniel points out that value investing should significantly outperform growth investing in years to come. 
 
Investors need to be aware that merely being a cheap stock does not make it a value stock. At my firm, Wilsey Asset Management, we consider many other factors than just a low price to book value. For us, the company also should have a good value when we examine what we are paying for the earnings, sales and cash flow. 
 
It is also important to understand what the tangible assets are because a company with too many intangibles could fool investors into thinking they are investing in a company with a low price to book value. The low price to book may look good until the company must write down intangible assets. When this occurs, many investors are left with a surprise as the book value is no longer a good value. 
 
Also, very important for our firm's method is to verify that the company's debt will not force them into bankruptcy before they have time to recover. It is also crucial for investors to be patient and sometimes wait 2 to 3 years, maybe even a bit longer for the turnaround. It is worth the wait because when that turnaround happens it could easily be a 50 to 100% gain that year. Think about that, if it takes four years to get a 100% gain. Divide the gain by the number of years and that is a simple return of 25% per year. Is that worth the wait? Even at only 50%, that is a still a yearly return of 12.5%. I think it is well worth the wait and that is the reason we stick to what has worked for our firm and for value investors for the past hundred years. 
 
I will warn investors once again, do not follow the herd into ETF's and index funds. Your returns will suffer and once again investors will blame the stock market calling it is too risky. Listen to the wise professors and historians not the cheerleaders on the business networks. 
 
The stock market is not risky if you understand you are investing in equities which is nothing more than a small piece of a large company AND that you paid a low price for that equity!