Someone emailed me this question:
“What are your thoughts on how the rise of passive investing such as index ETFs will affect value investing opportunities going forward? Will it become easier or harder for a value-oriented stock picker to find mispriced opportunities when more and more money becomes passively invested?”
Theoretically, it will become easier for value investors to pick specific stocks as indexing increases in popularity. In particular, there should be more opportunities in smaller value stocks. I started investing as a teenager in the late 1990s, which was a great time for a value investor who did not care if the stocks he found were big or small, exciting or boring. In the late 1990s, there was a boom in dot-com-type stocks and in big stocks. So, anything with dot-com in its name – whether or not it was profitable – was attracting money.
But you also had legitimately solid businesses – like Cisco Systems (CSCO, Financial) – trading at absurdly high price-earnings ratios. On top of all that, you had high prices on giant, blue-chip growth stocks like Coca-Cola (KO, Financial), Gillette, etc. Coca-Cola stock hit a price sometime in 1998 that I am not sure it is really that far above now. Obviously, it has paid dividends in the meantime, but it is not that cheap now. Meaning it was obviously way too expensive in 1998. Warren Buffett (Trades, Portfolio) even talked a little about how prices were too high on a few of the stocks he owned and really liked. Everyone remembers the overall stock market was overpriced around 1998. What they do not remember is how unaffected huge numbers of small, boring stocks were by all this.
For example, a stock I owned back then was J&J Snack Foods (JJSF, Financial). This is a high-flying stock today. In fact, I think its P/E may be higher than Coke’s right now. But it was not priced that way in the late 1990s. You can see this dramatic mispricing between the two stocks in the way that – over the last 20 years – J&J Snack Foods has had an annual capital gain of something like 15% a year in its stock price while Coca-Cola has had an annual capital gain in the low single-digits. Part of this is because J&J Snack Foods was smaller and had more room to run in terms of growth than Coca-Cola did. Another part of it is the P/E multiples. Back in the 1990s, J&J Snack Foods was valued at a much lower multiple than Coke. Today, it is valued at a somewhat higher multiple than Coke.
Another example – which I also owned because I had learned about the company while working as a cashier at one of its stores – of this 1990s bifurcated market is Village Supermarket (VLGEA, Financial). In the 1990s, stocks were supposed to be expensive. Village was cheap. Really, really cheap. Why? There were some legitimate reasons for its cheapness. It had experienced operational problems in the past. Essentially, the stock was cheap because Village was a smaller, less well-known stock controlled by a family in a boring offline business. It was a supermarket running stores under the Shop-Rite banner in the state of New Jersey. It might have been a more expensive stock if it had a big market cap, if its stores spanned the entire country or if the stock traded under the name Shop-Rite instead of Village.
Anyway, the company had a long runway in terms of potential margin expansion. So that explains a lot of the 13% or better annual returns over the last 20 years. The pricing of the stock explains a lot of it too. Village was not at what I thought peak margins were for the company and yet, the P/E was low. There was a time when Village actually had a P/E in the five to 10 range year after year when the overall market was pretty pricey. For many years now, Village has had a P/E more like 15. And – to be frank – the company’s prospects are worse now than they were 15 to 20 years ago. The industry’s prospects are worse. Additionally, Village is much closer to peak margins today than it was in the late 1990s.
So you have a multiple of 1.5 times to three times what it had been trading at in the 1990s and yet, the business has less potential upside now than it did in the 1990s. By the way, I would say the same thing is true of J&J Snack Foods. I am not knocking either business. I like both Village and J&J Snack Foods, but independent of price – the future growth prospects of both companies are less good than they were in the 1990s, yet the multiples at which the stocks trade are 1.5 to three times higher. For example, I really would not say Village has much better prospects than Kroger (KR, Financial) now, yet they are priced similarly. Also, I would say J&J Snack Foods and Coca-Cola have more similar future prospects now than they did in the past – and yet J&J probably has the same or higher multiple as Coke. I would not bet on Kroger over Village or Coke over J&J Snack Foods, but it is a hard race to call at the odds being given on these pairs of stocks.
That was not remotely true in the late 1990s. There was no way Coke – as a stock – was ever going to outpace J&J Snack Foods over the next 10 to 20 years starting from the late 1990s. Objectively, J&J Snack Foods had as good or better a future ahead of it (it was a lot easier for management to take actions that would move the corporate needle at J&J than at Coke) – and yet Coke’s multiple was many, many times higher than J&J's P/E. Even though I was only a teenager, I could clearly see stocks like Village and J&J Snack Foods were priced very, very wrong. In fact, the overvaluation of high-tech, high-growth and just plain big and well-known stocks in the late 1990s made it easier to see this.
The late 1990s and early 2000s were one of the best periods for me as a stock picker. Yet, stock prices really were not low overall from about 1998 to 2003. Even after the high-tech stocks and the big stocks started really declining in price – they stayed too expensive to safely buy for many years. Meanwhile, you barely noticed the crash at all if you were in small, boring value stocks like Village and J&J Snack Foods. I keep using these two names because I owned them, but there were lots of weird mispricings in the late 1990s due to “herding” of investors into the best-known names in an industry.
I also owned  Activision Blizzard (ATVI, Financial). What got me interested in Activision was actually looking at Electronic Arts (EA, Financial). The management at Activision was better and it was run more like a business that would benefit shareholders than EA was. I read both their annual reports and liked Activision quite a lot better. The weird thing, though, is that I think a lot of investors owned EA and not Activision. Now, I can understand getting that wrong in terms of which company to bet on. That is understandable. But EA trading at any sort of premium over Activision really did not make much sense from any sort of comparison of the two. It was a weird mispricing, like if investors decided Mattel (MAT) was better than Hasbro (HAS) just because Mattel was bigger and better known as a stock or that Coke  was better than Pepsi (PEP) or something like that. Actually, you can see a bunch of comparisons over the last 20 years where the less well known of a pair of stocks actually outperformed the better known stock in that twosome. When you look under the hood of the businesses, there is sometimes an intrinsic value growth reason for this. But, a lot of times there is not much of one. It is just this weird thing that happened in the second half of the 1990s where investors were always all piling into the bigger, better known brands and stocks.
What does this have to do with indexing? Well, it was the last time I remember that across the entire market you had this weird bias in selection toward a certain kind of stock (better known and tied to tech were the two biases in the 1990s). I have seen some misjudgments in sectors since then. For example, I own Frost (CFR, Financial). It is a bank in Texas that is an especially interest-rate-sensitive bank. One thing I have noticed is investors have treated all banks the same regardless of how sensitive those banks are to rising interest rates. So, Frost has performed great over the last year as a stock, but so has Prosperity (PB, Financial). Prosperity is also a Texas bank I like a lot. Frost, however, is one of the most interest-rate-sensitive banks you will find, whereas Prosperity is one of the least interest-rate-sensitive banks. Now, go chart the stock prices of both day-to-day, week-to-week and month-to-month. They both look like they respond to expected future interest rates and they both seem to move almost exactly in lockstep. That is weird, it should not happen. Frost’s future earnings depend a lot more on the Federal Reserve Funds Rate than Prosperity’s.
Something I noticed when I started looking at banks was investors – even value investors – may do some stock picking when it comes to the very biggest banks in the country. But once you get past Wells Fargo (WFC), JPMorgan (JPM), Bank of America (BAC), U.S. Bancorp (USB) and Citigroup (C) – investors pretty much give up on picking specific banks by figuring out differences in their normal earnings.
So you see things where two banks are priced at about the same P/E today even though one of those banks will be earning about the same amount regardless of whether the Fed Funds Rate is 1% or 3% in a few years while the other will be earning twice as much in the second scenario as it would in the first. I do not see big investors picking specific banks below the very biggest. There are investors who bet on banks as a group, but I just do not see any evidence for stock picking when it comes to individual banks. I think that is a mistake. I like banks. But the banks I picked for the newsletter I used to write were all regional banks. The banks among that group I liked best were those that had the best combination of being interest rate sensitive and being in high-growth states. Frost and Prosperity are both in the same high-growth state, but the former is interest-rate-sensitive while the latter is not. Meanwhile, Frost and Bank of Hawaii (BOH) are both interest-rate-sensitive. However, Frost is in the high-growth state of Texas while BOH is in the low-growth state of Hawaii. So when people ask why I picked Frost instead of spreading my bets across a lot of different possible banks – that is why. I woul be fine diversifying, but I do not want to diversify away interest-rate sensitivity. Rates will be higher, so I should bet on the bank that benefits most from higher rates. Likewise, I do not want to diversify away high population growth in a bank’s local market. Frost’s branches are in places that can grow close to 2% a year. Bank of Hawaii’s branches are in places that can grow close to 0% a year. If I buy equal amounts of the two banks instead of picking one over the other – I will be giving up these advantages.
That is what index funds eliminate. Worse yet, index funds buy bigger stocks over smaller stocks. As a rule, smaller stocks should be better than bigger stocks. Why? Because a stock’s size is determined by its market cap – not by features like gross profits, net profits, free cash flow and so on. So there is a bias toward high prices built into any system that tilts toward higher market caps instead of lower market caps. Market cap weighting causes an expensive stock bias. It is not intentional, but it happens. There is a second bias which is that companies with smaller market caps tend to have lower sales. Companies with lower sales tend to grow those sales faster than companies with higher sales. So there is an anti-growth bias in an index.
Now, to be fair, there will tend to be a quality bias in an index. If you look at the biggest public companies in the world – they tend to be better businesses than all the other companies. So, indexes should introduce biases toward inflating the prices of already high-priced stocks that are likely to grow slower than other businesses in the future, but which have better features in terms of competitive position, high return on equity and good free cash flow conversion. This is especially true in the U.S. Historically, the way public companies have financed themselves in the U.S. is with retained earnings. This is less true in all other countries in the world. Sometimes, it is a lot less true. Even in countries like the U.K., Germany, France and Japan – you have more use of funds that are not retained earnings from past years. So you have things like share issuance (dilution) and bond issuance. U.S. companies that go private use debt, but those that stay public tend to fund almost all their growth simply through what they have already earned. This is important because it means there is a large bias toward older and historically more profitable companies in the largest public companies in the U.S. So, something like the S&P 500 (which is market cap weighted) will tend to have a bias toward really good, really old companies.
There will, of course, be a severe momentum bias in any index. So you are going to start by having a portfolio that is biased toward older, high ROE businesses. I am fine with that, but then you are going to tend to buy more of whatever goes up in price and sell what goes down in price. The companies you add to the index will tend to be overpriced relative to the companies you drop from the index. So you will have a bias toward high-quality and high-price momentum stocks – but you will be dropping value stocks and replacing them with more expensive stocks. Over time, an index can easily become biased against value instead of in favor of it. Now, over time, value works. Quality works too, but value does work. And if you are biased against something that works – that is going to hurt your performance.
An index fund that is capitalization weighted will be anti-value. As an individual investor, you can choose to be pro-value. So if more and more people embrace indexing – this should lead to more situations like what we saw in the late 1990s. That was a great time to be a value investor. It was a really great time to be a buyer of small, boring stocks. They were everywhere. It is much harder to pick stocks today than it was in the late 1990s and early 2000s because the investing public is not so focused on just dot-com companies and big, blue-chips stocks. It is more rational.
Index funds are a net positive for stock pickers. They add liquidity and reduce selectivity. Any time you have the opportunity to trade more frequently with someone who is less selective – you are going to benefit from that. An index fund is an ideal partner to have on the other side of a trade. Index funds are the very definition of a “know-nothing investor”. If you think you know something about a stock, then you will be happy to take the other side of a trade from an index fund.
Finally, I should stress that I am not against investing in index funds. I think index funds are better than most hedge funds and mutual funds. I think common stock index funds will outperform most bond portfolios – no matter how well chosen. Common stocks are the best asset class. If they are not clearly overvalued, you should hold them. So saving the same amount of money every week, month and year to put into an index fund is a fine idea. Personally, I would not add to an index fund when I think the S&P 500 is overvalued, which I think it is currently. So I would just add to cash instead of adding to the index fund. But  if I owned an index fund, I would not sell it just because the market is overvalued. I do not believe in selling stocks except to buy other, better stocks.
So net savers should choose between adding to specific stocks they have picked themselves, adding to an index fund and adding to cash. If you have specific stocks you like better than the overall market, you should add to those whenever they are not overpriced. If you do not have any good ideas of your own that are not overpriced, you should just add to a Vanguard-type S&P 500 index fund. Then, when you know the index is clearly overvalued, you should just add to your cash holdings. Adding whatever you manage to save this year to cash instead of an index fund will allow you to buy more stocks than you otherwise would be able to when the market declines. Ideally, I think an investor should try to be as selective as possible. So I think you would like – when you can find stocks that are not overpriced – to own as many specifically chosen stocks as possible. I think stocks you picked yourself are always the first choice, an index is the second choice and cash is the third choice. Most people reading an article like this are going to want to work at picking individual stocks, so the advice I laid out is good advice.
For investors with no interest in the market, I would recommend never owning bonds or actively managed mutual funds and simply put all your savings into an S&P 500 index fund month-after-month for your entire working life. That will work out fine. It will do better than inflation and will grow your capital a little. The result will be lumpy, but if you save enough – especially early on in your career – you will have enough to retire on using an S&P 500 index fund and nothing else. Personally, I pick stocks, but I would recommend just an S&P 500 index fund for probably 90% of the people out there who are saving for retirement. I am asked all the time to recommend mutual funds. The answer is: I would not. If you do not want to pick stocks yourself – just pick an index fund. But if you do want to pick stocks yourself – index funds obviously make it easier. Index funds reduce the selectivity in the market. The less selective other market participants are being – the greater the return will be to those who are being selective.
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