“Buy low, sell high” is every investor’s mantra, though it’s rarely as simple as it sounds. All market participants — whether professional wealth managers, retail investors, or speculators — hope to buy stocks or securities that will rise in price within a targeted time frame and thus allow for a profitable exit. While hope isn’t an investment strategy, there are other options available.
In that vein, what is value investing? And can it be a worthwhile approach during periods of heightened risk, such as the one we’re in now? Value investing is about finding stocks that are selling for way under their intrinsic value and waiting for them to reach their potential. In short, value investing is an effort to identify and purchase undervalued assets. Metaphorically, it’s the search for dollar bills that can be purchased for 65 cents. That discount can represent a margin of safety for investors, that could reduce the risk of a permanent capital loss from an investment.
Value investing has long been touted as one of the most effective investment strategies, which has earned it a devoted following. Warren Buffett and Charlie Munger, perhaps the most famous practitioners of a value investing strategy, used it to turn Berkshire Hathaway into one of America’s most successful holding companies. The duo made a fortune for themselves and for many of their investors in the process.
As a value investor, the biggest determinant of risk is the price you pay for an investment. The lower the price relative to intrinsic value, the lower the risk. When implemented with discipline and prudence, it’s a strategy that can be applied in any market — even when risk is high.
Is Value Investing Dead?
To answer this question, it helps to look at the current state of value investing and how it measures up to other strategies. Although value investing focuses on underestimated stocks, something like growth investing prioritizes buying shares of stocks that are expected to grow at a rate above the expected industry or market average. Value investing has fallen out of favor in recent years, but growth has prospered over that same duration. This has led some industry pundits to declare the end of value investing.
When major indices are hovering around all-time highs, critics of value investing tend to get louder. Value investing has been out of favor for the past decade because of the strong performance of growth stocks. Value investors will point to past bubbles and valuations that don’t match the underlying business fundamentals, but many investors would rather just chase a rising price during bull markets.
Many people don’t have the tools or the psyche to invest in companies that are out of favor or unknown. And even those that do understand this approach occasionally forget that value can be found in any market — you just have to know where to look.
Financial pundits have proclaimed the death of value investing numerous times over the years, and several myths associated with this approach have invariably arisen the longer it has remained in existence. Some of the most prevalent myths include:
- Value investing is all about picking legacy and industrial businesses. Value investing isn’t specific to any industry or sector. In 2008, when oil was trading at $150/barrel, the entire energy industry — an “old school” field by all accounts — was incredibly overvalued. While most market participants believed high oil prices were the new status quo, seasoned value investors would have wisely stayed away from energy. Value investing success hinges on identifying unsustainable trends that will eventually revert and then staying on the right side of those trends. In 2010, Apple traded at a P/E ratio below 10; in 2012, Alphabet shares traded at a P/E ratio of around 12. Good value investors jumped on these opportunities to buy into tech stocks at a low price, and they were rewarded handsomely in the years that followed.
- Good value investors always outperform. The value investing vs. growth investing debate isn’t so much a debate as it is a difference of perspectives. While value has been shown to outperform growth over the long term, there can be multiyear cycles (e.g., the years preceding the dot-com crash or the decade following the Great Recession) when growth outperforms significantly. The returns achieved by some growth investors during these periods typically fuel the spread of the next myth.
- Growth stocks are better investments than value stocks. Before the Great Recession, picking undervalued stocks was such an effective strategy that many investors considered it the only truly worthwhile investment approach. In the years since, technology stocks (the core assets of a growth stock portfolio) have continued to soar to even higher valuations and reward investors who seemingly paid a premium to acquire them. Over time, however, research suggests that value stocks outperform growth stocks (and to a lesser extent, small-cap stocks outperform large-cap stocks). The recent outperformance of growth stocks relative to value investments has rarely been seen throughout history. In similar scenarios in the past, the reversion back in favor of value has been sudden — possibly to the detriment of growth stock shareholders who chased rising share prices at the wrong time.
- Value investing can reduce the risk of permanent capital losses. Value investing is a cautious exercise by nature, and practitioners of the strategy can reduce the risk of permanent capital losses that accompany dramatically overvaluing an already-expensive stock or investing in stocks that destroy value rather than create it. During a market crash, however, value stocks are not immune to temporary downside price pressure. Crashes are typically driven by forced selling and emotional selling rather than thoughtful deliberation about stock valuations, and these forces are fickle. That’s why counter-corrective moves — when zealous investors gobble up undervalued stocks and drive prices back up — are often just as powerful. Even so, there is no such thing as a risk-free investment. With the upcoming election priced as the worst event risk in history, there are valid reasons for all investors to be cautious in the months ahead.
Value Investing Challenges
Buying cheap stocks sounds like a rational approach to investing in the stock market. However, seasoned investors understand the truth behind Keynes’ famous maxim, “The market can stay irrational longer than you can stay solvent.” For all the preparation and forecasting you do to make sure your investments materialize, the market doesn’t care — and will react as it always does. Patience is key, but it’s equally essential to have some perspective regarding what the market will and won’t do.
As value investors, we look for stocks that we think the market has irrationally cast aside. We expect these stocks to create value over time; we predict the rest of the market will notice the discrepancy between a company’s intrinsic value and the price of its undervalued shares and then purchase the stock until the discrepancy disappears. This sometimes happens remarkably fast, but our patience can be tested as we sometimes wait years for the market to agree with us.
The second major value investing challenge? You’ll often find yourself investing against the herd. It’s easy to invest in popular stocks and buy shares of companies that are seemingly poised to take over the world. It’s more difficult to buy and hold shares of companies that most investors haven’t heard of — or that nobody understands or likes. Being a contrarian investor is a necessarily lonely endeavor.
Back in 2004, shares of Merck’s stock (MRK) plummeted more than 40% after the pharmaceutical company recalled its blockbuster arthritis drug, Vioxx. Nobody wanted to touch the stock. Well, almost nobody. A few investors noticed that the company held more than $16 billion of cash on its balance sheet and that the company’s other drugs were generating enormous free cash flow. Value investors that bought in after this crash and held onto their shares were eventually rewarded because the stock’s price has tripled in the years since while also paying out a generous dividend.
Similarly, nobody wanted to buy small-cap stocks in March 2009. Why? These are often seen as more volatile than shares of blue-chip companies. But from 2009 to 2011, the Russell 2000 small-cap market index outperformed the S&P 500 month after month. Just another piece of evidence that value investments aren’t limited to a particular industry, index, or market capitalization size.
Which brings us to the last big challenge associated with value investing: benchmarking. For better or worse, value investors do not attempt to mimic the performance of the S&P 500. Instead, they simply try to determine whether a stock is underpriced. If they believe it is, they invest. Sometimes that translates to dramatic underperformance versus the major indices, and sometimes it results in significant outperformance. Instead of focusing on matching or beating a market index, many value investors will rely on exhaustive research to ascertain a stock’s true value — and that’s precisely why they’re successful.
Identifying Intrinsic Value
A share of stock represents a partial ownership stake in a business that happens to be publicly traded. At Pekin Hardy Strauss Wealth Management, we approach stock picking the same way we would invest in a private business.
We try to use multiple methods to determine a stock’s intrinsic value. We consider the business and its industry, and we examine its historical valuation metrics and the valuations of its peers. We often rely on a discounted cash flow analysis, a consideration of replacement value, and numerous other techniques based on the particular company and industry we are examining.
In defensive industries such as food and pharmaceuticals, demand remains consistent regardless of whether the economy is expanding or in recession. Most industries, however, are subject to a certain degree of economic cyclicality. As jobs grow during an expansion, wages rise, consumer spending and capital investments increase, bankruptcies and defaults decline, and corporate earnings tend to grow. When the economy contracts, the opposite happens.
Value stocks aren’t immune to cyclicality, and we always attempt to adjust earnings expectations based on the current business cycle. During a recession, earnings are probably too low; in late expansion periods, they’re often too high. We generally value companies using a midcycle earnings estimate, which helps us avoid paying too high of a price during a bullish market and allows us to capitalize on undervalued stocks during a bearish one.
Regardless of how confident we are in our investment, we’re always prepared for a drawdown. Value stocks aren’t immune to market crashes, which is why value investors must diversify their portfolios across asset classes, including some that aren’t correlated to stocks.
An Organic Market
Ben Graham, mentor to Warren Buffett and one of the earliest practitioners of value investing, famously said that “in the short run, the market is a voting machine, but in the long run, the market is a weighing machine.”
What did he mean by that?
Essentially, short-term prices are driven by capital flows. When stocks become popular, investors typically buy their shares because the price is rising rather than because those shares are undervalued. Intrinsic value will largely be ignored as long as the price continues to rise.
Eventually, this can lead to a stock becoming overvalued when a company’s share price exceeds its intrinsic worth. Like many companies in the months leading up to the dot-com crash, Cisco Systems saw its stock price soar to multiple times its true value from 1999 to 2000. Unlike some of the other companies that experienced sky-high valuations, Cisco’s business was actually doing very well. However, when the stock market bubble popped, Cisco’s share price tanked. Nearly two decades later, the company’s earnings have grown significantly, but its share price remains well below its early 2000s peak.
More recently, stocks like Uber and Tesla, which have historically burned through cash at an unsustainable clip, have relied on their investment popularity to remain afloat. Both are among the most traded stocks in the world — and the latter is now worth more than all other publicly traded auto companies combined — but we believe that both are quite overpriced. As consumers, we love Uber’s ride-sharing service and Tesla’s cars but also believe both businesses are ludicrously overvalued by investors.
A Potentially Effective Strategy
Value investing persists as an effective investment strategy because it’s generally profitable and, moreover, it helps to reduce some of the risks associated with many other approaches. As one example, we at Pekin Hardy Strauss Wealth Management occasionally come across companies that we simply don’t understand well enough to value appropriately. In those instances, we adhere to Buffett’s assertion that “risk comes from not knowing what you’re doing,” and we pass on those stocks.
Even a decade of favorable performance can become a moot point if you buy a stock when it’s overpriced. Good value investors try not to do this, and so avoid having to hold onto a stock for years just to break even. Instead, a wide body of research suggests that those who adopt long-term, value-oriented strategies achieve better returns than stock pickers looking for short-term winners during a bull run. While Warren Buffett is often considered the greatest value investor, the list of those who have deployed the strategy successfully is lengthy — and it grows every day.
How You Can Realize the Benefits of Value Investing
In our minds, value investing remains one of the best strategies for constructing a profitable portfolio. And we’re not alone. Many wealth management firms claim to adhere to the principles of value investing when managing clients’ money, and some do follow through on their word. To find one that has mastered these principles and isn’t merely giving them lip service, high net worth investors should be prepared to ask potential advisors a number of relevant questions, including:
- What is the background and experience of your research team?
- How do you find ideas?
- What does your investment process look like?
- How do you monitor stocks that you’ve invested in?
- Could I see an example of a written stock recommendation?
- Can you describe some of your recent investments?
- What steps do you take to determine a stock’s value?
- What steps do you take to learn about the companies you’re considering investing in?
- What are some investment mistakes you’ve made in the past, and what did you learn from them?
A good wealth manager will be happy to answer these questions (and glad that you asked them). If you’re a high net worth individual seeking a financial advisor — or if you just want to learn more about what we do — contact Pekin Hardy Strauss Wealth Management. We’re eager to answer these and any other questions you might have.
This commentary is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy”, dba Pekin Hardy Strauss Wealth Management) for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any security. The information and data in this article do not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of any particular investment or strategy, there is no guarantee that the type of investments or strategies discussed herein will outperform any others in the future. Although information has been obtained from and is based upon sources Pekin Hardy believes to be reliable, we do not guarantee its accuracy. Past performance is no guarantee of future results. The S&P 500 Index includes a representative sample of 500 hundred companies in leading industries of the U.S. economy, focusing on the large-cap segment of the market. The Russell 2000 Index is a widely recognized unmanaged index that measures the performance of the small-cap segment of the U.S. equity universe. Pekin Hardy holds Cisco Systems (CSCO), Merck & Co., Inc. (MRK), and Tesla (TSLA) in some of its client accounts.