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Thomas Macpherson
Thomas Macpherson
Articles (109)  | Author's Website |

The Future of Value Investing

As value investing heads into its 2nd century, is it as relevant today as in Ben Graham's time?

June 27, 2017

“The four most expensive words in the English language are ‘This time it’s different.'"  Sir John Templeton

“Trends keep going until they don't.” – Carlos Santiago

Since I started in the investment world over 20 years ago, one concept has been the north star of my methodology – over time, value investing will outperform growth investing. Unfortunately the validity of this tenet has been stretched further and further in recent years until – at this point – it resembles a rubber band ready to snap.

Since the 1990s growth has outperformed value in nearly every cycle. This even includes the 2008-2009 market swoon.

Many value investors old enough to be in the business before the mid-1990s are beginning to question the viability of core value tenets. One such individual is Jeremy Grantham (Trades, Portfolio) at GMO. In a two-part article (it can be found here), Grantham openly confessed that traditional value investing has ceased to work since the mid-'90s.

I can certainly attest to this. My returns at the Nintai Charitable Trust (which I used to manage) from 2009 to 2015 as well as my time at Dorfman Value Investments (since June 2016) have demonstrably proven this to my considerable chagrin. My outperformance over the 10-year period 2006 to 2015 occurred in large part because I lost far less than the Standard & Poor's 500 during the market swoon in 2008-2009. I achieved this by holding far more cash than others. Since 2010 (through May 30) I have underperformed in five of eight years and in total roughly matched the S&P 500 (including costs).

The more things change, the more things continue changing?

Whether it was Eugene Fama and Kenneth French’s paper “Value vs. Growth: International Evidence”[1] or Tweedy Browne’s “What Has Worked in Investing,” value investors have been confident in pointing out that over the long term value generally (though not always) outperforms growth. That expectation of traditional outperformance has become some thin gruel on which to survive in this market.

Of great interest (at least to me) is the breadth of underperformance within the value investing community. For instance, my co-worker John Dorfman is a dyed-in-the-wool value investor seeking companies with low price-earnings (P/E), low price-book (P/B), low price-sales (P/S), strong balance sheets and decent return on equity. My type of value investing is so far from Dorfman’s that he questions whether I’m a value investor at all (it makes for interesting conversations). I look for no-debt, high ROIC, high ROE, high ROA, high FCF/percent of revenue and a significant discount to my estimated fair value. I utilize a DCF method to calculate estimated intrinsic value, and Dorfman does not. What’s interesting about this is even with the differences between our methodologies, he and I have both underperformed in the short term and outperformed in the long term.

So what gives? Is value investing dead? I’m one who believes it isn’t, but value investors have found themselves in a market that makes little to no sense to them. I would posit several factors have changed the methodology of finding value in today’s markets.

Change in market pricing

Part of this underperformance is the change in what investors are willing to pay for growth. In the period 1970 to 1995, the average P/E ratio was roughly 14. That is to say investors were willing to pay $14 for $1 of present earnings. The period after that – 1996 to 2017 – saw an enormous increase in the amount investors were willing to pay. During this time the average P/E ratio ballooned to roughly 23 – a 64% increase. This increase reflects an extended period of low interest rates and perhaps a consensus that earnings growth will be quite high in the ensuing decade through 2027.

Connectivity is wider and deeper

From the 1930s until the mid-2000s the concept of value investing was pretty straightforward. Find a company or industry that suffered a setback, confirm the stock is underpriced, purchase shares and wait until the general markets see the light. This model worked well until the severe bear market of 2008-2009. Many successful value investors purchased shares in financial services at that time on the assumption that cheap valuations were terrific opportunities. Unfortunately, many of these companies continued dropping until they reached bankruptcy [2]. It wasn’t obvious to many that a collapse in housing prices in Peoria could lead to the destruction of Washington Mutual – or even Lehman Brothers. Going forward, value investors are going to need to see connections they’ve never seen previously. Risk is more complex with more dependencies and potentially unseen interactions.

A general and willful abdication

Fifty years ago it was a given that you could open a company’s annual report and review financial data pretty much the same way as a thousand other stocks. Earnings were based on GAAP, and free cash flow was based on free cash flow. Those were the days. Today any type of measure might be used to describe a company’s financials – EBITDA, non-GAAP earnings, balanced free cash flow, etc. The ability to find value based on egregiously poor financial statements make it harder to develop an accurate intrinsic value.

I should be clear none of these changes are an excuse for underperformance. No investor wants to hear about why his or her money manager has performed poorly. The investment management business is an exacting taskmaster.

Conclusion

Being a value investor has always meant being out of step with the broader markets. To continue this tradition, value investors will need to change their perspective. Not by losing the tenets of Ben Graham, but rather by applying them differently in today’s financial markets. Cutting through much of the noise – market prognosticators, Wall Street marketing machines, and other such financial carnival barkers – will be necessary to focus on the only important measure a value investor cares about: price to value. By utilizing data that simply wasn’t available in Graham’s day, value investors are not part of a dying class but rather an evolving species.

[1] “Value vs. Growth: International Evidence,” Eugene Fama, Kenneth R. French, August 1997

[2] Many prominent value investors doubled down on financials by applying the standard value approach of buying on the dips. Unfortunately these dips became crevasses. Much like many value investing tenets, this one took a horrible beating in the Great Recession.

About the author:

Thomas Macpherson
I served as CIO of the Nintai Charitable Trust and consult with Dorfman Value Investments as an investment advisor. I look for companies with high ROIC, significant free cash flow, no debt and that trade at a deep discount to fair value. Much of my writing consists of thoughts on the Nintai Charitable Trust portfolio. I am the author of "Seeking Wisdom: Thoughts on Value Investing". It is a book written to get investors thinking differently about their investment approach. Unless otherwise stated, views represented in my articles are based on my former role as CIO of the trust, which I personally managed.

Visit Thomas Macpherson's Website


Rating: 4.8/5 (11 votes)

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Comments

Grahamites
Grahamites premium member - 4 months ago

Tom - Congratulations on an absolutely outstanding article. I can not agree with you more on this:

"By utilizing data that simply wasn’t available in Graham’s day, value investors are not part of a dying class but rather an evolving species."

batbeer2
Batbeer2 premium member - 4 months ago

Thanks for an interesting article.

You say:

>> The ability to find value based on egregiously poor financial statements make it harder to develop an accurate intrinsic value.

I diasgree (in part).

It seems to me that if, as a value investor, you would wish for better financial statements, this implies that you believe your outperformance hinges on your ability to be contrarian (suffer pain). In other words, the value investor sees what everyone else can see (level playing field) but unlike most investors is unafraid to buy "the falling knife". That tyoe of value investors wins because he dares to succeed indivifually where most market pariticipants would rather fail collectively. That is not a bad idea.

BUT

One could also argue that outperformnce of a value investor hinges on the ability to identify valuable assets where it is not immediately obvious. Some asset that is simply not accounted for at true value (perhaps unused real estate or maybe untapped pricing power etc.). If as a value investor you are capable of uncovering such hidden but valuable assets, then you do not have to suffer pain at all. You are very confidently paying far less for something that you know the accountants overlooked.

I'm not arguing that the one approach is value investong while the other is not but perhaps you can see that the one schism of the church of value investing would hope for worse accounting whie the other would pray for better accounting.

Just some thoughts.

fung9815
Fung9815 - 4 months ago    Report SPAM

Great article, but I beg to differ on one part of your post.

Value investors don't (and shouldn't) only invest in the so-called value stocks, i.e. low P/E or P/BV stocks. There are values to be found in the so-called growth segment as growth is an important variable in valuation. There have been many respectable value investors invested in the likes of Amazon, Alphabet, Facebook, etc., simply because their high valuation is justified by their long-term growth. With perfect hindsight now, buying Alphabet/Google at 20x P/E is seemed as a no-brainer bargain.

Of course, most value investors are trained to be conservative in estimating growth rates because all of us crave for margin of safety. Well, who said investing is easy?

Billrad
Billrad - 4 months ago    Report SPAM

Price is what you pay, value is what you get. most stocks are wildly overpriced right now as indicated by the slim number of good choices out there. (also the Shiller PE and the Buffett indicator are at historical highs. to be fair, Graham style net-nets are found at the bottom of a bull-bear cycle, not at the top (where we currently are). I think Value Investors are better advised to load their elephant gun with cash and wait for correction.

superguru1
Superguru1 - 4 months ago    Report SPAM

1. Value investing has future in investing in growth stocks at right price.

2. It seems most value investors were plain lucky in 2000-2001 that they did not invest in technology stocks. Most of them turned out to be not that lucky in 2008 as they did invest in financials.

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