What is value investing...really?
Fund investors like to label their managers -- you’re growth, you’re value. You invest solely in the US, only offshore, or maybe all over the world. You buy stocks, or you buy bonds.
Although we can’t invest in everything, we have a charter broad enough to invest in most publicly traded stocks and bonds. Our broad flexibility and conservative mandate means we have never been easy to label, but we always have been (and always will be) value investors. In our mind, all sensible fundamental investing is value investing - by which we mean buying a business or asset for less than what we believe it is worth under a number of reasonable scenarios.
The FPA Contrarian Value Strategy
The FPA Contrarian Value strategy (on which basis we manage the Nedgroup Investments Global Flexible Fund) is largely to purchase equity in under-valued businesses and high-yield and distressed corporate debt. If we have correctly assessed the opportunity, we believe our investments can deliver a better than market rate of return by virtue of a discounted valuation. The market will define some of these investments as value and others as growth. We describe them as opportunities to allocate capital to idiosyncratic investments that hopefully will allow us to deliver on our oft-repeated goal of producing an equity rate of return while avoiding a permanent impairment of capital.
Buying growing businesses with an adequate margin of safety is just as much a value investment as buying, say, a financial firm at a discount to tangible book value or a holding company at a discount to readily ascertainable net asset value. We’ve held all three types of investments in our Contrarian Value Strategy over the past decade.
When analysing businesses, we focus on the key performance indicators that we believe matter. Sometimes financial statements tell the story, and in those cases, investments typically appear “cheap” based on reported financial results. In other situations, information not in the financial statements might be most relevant, for instance, data like a company’s position on the cost curve, its subscribers/user base, its total addressable market, its customer acquisition cost, the lifetime value of a customer, or real asset marked-to-market. In these situations, our holding might appear “expensive” based on reported financial results, but not when one looks at these other factors. Our value approach is the same no matter what the ultimate driver of intrinsic value.
We suspect that balance sheet sources of value will prove a less fertile source of opportunity than in the past, given evolutionary changes in the economy and business models over the past 30 years. In the past few years, the team has spent much time building a base of knowledge in businesses that are capital light, demonstrate outstanding economics and are likely to offer substantial organic growth over the next decade. Some of these companies are too hard for us to underwrite and others trade at values that seem devoid of a margin of safety, but others, like Facebook, Expedia, JD.com and Baidu, have made it into our portfolio.
The challenge of finding value opportunities
Admittedly, no bright line divides growth and value. Lacking a more robust methodology, index funds place some companies into both buckets. A company with a low price-to-earnings ratio but a high price-to-book may find some portion of its market capitalization allocated to a value index and the remainder in a growth index. With active and passive funds building ever larger exposure to growth stocks, the lack of oxygen left in the room for value stocks has triggered some wilting in price. That, along with somewhat higher volatility, has allowed us to initiate new positions. When investors become fearful, we like to take advantage of indiscriminate selling. In the first half of 2018, that allowed us to establish eleven new long positions and exit seven. This is more portfolio movement than we’ve had in years.
The market hasn’t presented a similar opportunity in corporate bonds. Low yields and a lack of appropriate discounting of risk have kept us away.
At purchase, the corporate debt in our portfolio should offer a yield well in excess of a risk-free rate like an equivalent maturity US Treasury note. The greater our expectations of interest and principal at maturity, the lower the yield we are willing to accept, yet our minimum threshold is still generally 10%. When we think a bond has a strong possibility of restructuring, we insist on a higher yield-to-maturity at purchase, usually in the mid-teens. None of those conditions exists today, which explains our negligible exposure to high-yield bonds.
Markets and Economy
It’s no surprise that risk assets don’t provide the highest margin of safety in the context of the almost decade-old bull market and economic expansion. In our recent bi-annual FPA Investor Day, we provided commentary and slides that speak to the state of the markets. Rather than repeat it all here, we refer you to our prepared remarks for this bigger picture perspective.
In summary, the global equity and corporate debt markets trade richly by almost every measure (price-to-earnings, price-to-book, market cap to GDP, bond yields, high yield OAS).
As stock prices have risen after the Great Recession, the S&P 500’s free cash yield has reached cyclical lows (excluding financial stocks, whose free cash yield is calculated differently). This meagre, mid-single-digit yield was last this low in 2008, the prior market peak.
Since then, stock prices have risen along with US Treasury yields (a proxy for a risk-free rate) compressing the equity risk premium. The current 417 basis point spread is less than half the average since 2009 and well below its peak, which makes a case for the cautious allocation of capital. This doesn’t mean there is nothing to do, just less than we would hope.
Optimism hasn’t been this high since 2000. Stocks last took a serious whopping a decade ago and many investors hold the view that it’s hard to lose money.
There is a view that stocks are much cheaper outside the U.S., but that’s a view from 30,000 feet that doesn’t hold up once you drill down and compare a US company to a reasonable, albeit imprecise, analogue abroad. Like-for-like-ish companies are priced similarly around the world, as we concluded when looking at the admittedly small sample size in the following table.
Some observations about the above:
- On a trailing twelve-month basis, Nike trades at 33 times earnings, while Germany’s Adidas trades at 26 times -- even though Adidas has grown earnings slightly faster over the last decade.
- Proctor & Gamble trades at a 12% discount to Unilever but at a substantial trailing twelve month price-to-earnings of 19.2 times, vs Unilever’s 21.9 times.
- Unilever did grow earnings at a faster clip over the last decade, but just 2.7% faster compared to P&G’s 1.9% – both rather meh, and if the future were to be in kind, poor justification for their valuations.
- SAP’s trailing twelve-month price-to-earnings, at 28.1 times is 70% higher than Oracle’s, which is hardly validated by SAP’s earnings growth in the past decade of just 6.8%. Oracle, with its far lower price-to-earnings ratio of 16.5 times had only slightly lower earnings growth of 5.9% over the past ten years.
Stocks are no bargain anywhere, but complacency seems to be almost everywhere – a potentially combustible combination. In the last 60 years, the S&P 500 has only been more expensive once, during the late 1990s tech bubble.
We will eventually have a recession and may end up with inflation, or perhaps even deflation. Our portfolio is set up to play the middle. Our stocks and the equity markets in general will likely perform poorly in a deflationary environment, but our cash position will likely outperform equities in such an environment and provide a source of funds for investment in what could be a period of distress. If we end up with inflation, well then, our cash will likely lag but our stocks should deliver some nominal benefit. As we have said, we manage this portfolio as if you have given us all your money (although we do not suggest that is the prudent course). But if one manages your capital as if one has it all and there’s no safety net, it tends to breed prudence. Of course, there are more hardy individuals who prefer life on the high wire.
There is, of course, a price for conservatism: under-performance for a period, generally followed by a shrinking business. We are fearful of neither.
One should demand an alignment of interest between investor and portfolio manager, and we believe we successfully deliver that. That might be harder for a passive fund, like an index or ETF, which should invite the investor with a long-term buy-and-hold philosophy and the internal gumption to not head for the hills when markets turn sour — a test rarely passed amid market declines.
We believe an active value manager will likely fare better in a declining market -- and hopefully scare fewer clients away and out of the market. A globally diversified value manager who invests in stocks and higher yielding corporate bonds and exhibits a willingness to hold cash should attract the independent investor less concerned about performing in line with any one index, particularly over shorter periods (and even be accepting of under-performance in the short term so long as there’s an acceptable reward eventually for such loyalty and patience).
The Crowd is rarely right, and this time is unlikely to prove the exception. When stocks do decline, they tend to fall more quickly than they rise. The good times that investors think will never end morph into bad times that investors think will never end.
 GDP = gross domestic product. OAS = option adjusted spread.
 For the last ten fiscal years beginning May 2008, Adidas has grown earnings per share at 10.6%, beating Nike’s 9.7%.