According to John Rogers (Trades, Portfolio), the founder, CEO and chief investment officer of Ariel Investments, value investing has changed substantially over the past several decades.
While he may not have the same kind of media presence of other value investors such as Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), Rogers still knows a thing or two about value investing. Since founding Ariel in 1983, he has grown the company into a $12 billion investment powerhouse. The flagship Ariel Fund was number one in Lipper's mid-cap core universe of funds in the period from the stock market's bottom on March 9, 2009 through Dec. 31, 2018.
Value investing has changed
Rogers believes value investing has changed substantially over the past decade because investors no longer pay as much attention to the price-earnings ratio as they once did.
In an interview with Morningstar last week, Rogers said, "I think, as value investors, price-earnings multiples have become less and less important." He goes on to note that even low price-earnings stocks "will decline substantially on bad news," and low-priced stocks will even decline following short-term earnings disappointments.
This is different from the traditional way of thinking for value investors. Value investing generally teaches that low price-earnings stocks have low expectations built into their price, so if there is an earnings disappointment, they are unlikely to decline substantially -- the downside is limited.
But that does not seem to be the case today, according to Rogers' analysis of the situation.
"Maybe it's because it's in the wrong sector, maybe it's in the wrong index, maybe just the earnings announcements are so dramatic that the stock deserves to decline a lot," he said.
No longer black or white
I think this is an interesting topic, and one that deserves further attention. One of the primary selling points of value investing is that buying cheap stocks limits your downside while maximizing your upside.
Benjamin Graham, the father of value investing, always concentrated on metrics such as the price-earnings and price-book ratios to try and determine whether or not a company was cheap. He believed there were no bad assets, just bad prices.
As the availability of financial information has improved, however, it has become harder and harder to find good quality, cheap stocks using the relatively simple price-earnings ratio. Instead, investors now have to spend more time and effort trying to establish whether or not a business is actually undervalued or if it is just cheap. If it is cheap, it is usually cheap for a reason, which could explain why many low price-earnings stocks are more volatile than their highly valued growth peers.
The price-earnings ratio has also lost some of its usefulness, in my opinion, because of the aggressive accounting techniques companies use to try and window dress their figures. While it is true aggressive accounting is something investors have always had to deal with, in recent years, the use of non-GAAP numbers and techniques such as aggressively capitalizing costs, which are widely accepted, have only made it harder for investors to sift through all the junk.
Avoiding value traps
So how do you avoid low price-earnings stocks that could be value traps, which lack the downside protection cheap stocks should offer?
According to Rogers, the secret is to concentrate on the balance sheet. If a company has a strong, cash-rich balance sheet without much debt, then the chances of investors suffering a negative shock are much reduced.
As Rogers put it in a recent interview with Business Insider, "If you don't have an overleveraged balance sheet, you can live through mistakes, and you can build a business for the long run. If you don't have the right type of balance sheet, when things get tough, that business can go away."
Disclosure: The author owns no stocks mentioned.
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