U.S. Market Report
By H. Terrence Riley III, CFA
What happens next? And Why GARP Works
So many uncertainties are in the air: The expiration of tax reductions and the automatic spending cuts by year end in the US, as well as the election later this year; the problems of Greece and the financial contraction in Europe, as well as the liquidity angst with the banks. And on top of all this, it seems we are witnessing a global slowdown. The equity market is a leading indicator. Over the few last years, the market anticipated a rebounding economy coming out of the recession and preferred trendier stocks with growth fantasies. Accordingly we saw the rise of Apple, Salesforce.com, etc. These stocks have run up in some cases for reasons more perceived than real. As economic and market uncertainties now approach the boiling point, we expect markets to focus again on facts more than hope. And one fact that has been proven over the long term is the benefit of value investing. Growth at a Reasonable Price (GARP) is style of value investing that has delivered superior performance over time and which has been developed in view of the best academic studies in the field of finance and investment management.Value is a Core Factor
There is probably no phenomenon in investment management that has been more studied and better documented than the outperformance of value stocks. Ben Graham and David Dodd, who both taught at Columbia University and whose students included Warren Buffet, published their famous “Security Analysis” in 1934. Their book focused on the benefits of purchasing stocks that appear underpriced based on fundamental analysis. They used tools like low price-to-book values and low P/E’s to identify undervalued securities. Similarly, in 1992 two professors, Eugene Fama and Kenneth French, published a famous paper that documented the outperformance of stocks that trade at low price-to-book values and smaller than average sized companies. And only recently, Brandes Institute updated a study where they divided U.S. stocks into 10 deciles based on value characteristics like price-to-book values. This new study found that from 1980 through 2010 the cheapest stocks outperformed the most expensive by 575%, and that this “value premium” extended to international markets. The basic idea to value investing is that you want to purchase assets and earnings at the lowest possible price relative to the “intrinsic value.” The stock market overreacts to both good and bad news and stocks become mispriced relative to a company’s long term business fundamentals. For various reasons, people move in groups some with a lag time. As a result of this tendency for group think and mass behavior, individual stocks and sometimes entire sectors become over or undervalued. Value analysis helps determine which is which.
Amgen’s Value Swing
Amgen provides a good example of the benefits of value investing. During the 1990s Amgen was a very hot stock. From 1993 through 2000 Amgen’s earnings grew at a rate averaging almost 20%. Such good growth encouraged investors to pile into the stock, which went from trading at 13 times earnings to more than 60 times earnings by 2000. For sure Amgen was a good “value” when it traded at 13 times earnings in 1993—the stock went from $4 per share in 1993 to nearly $64 per share by the end of 2000. However, at the P/E of 60, the stock was certainly no longer a value. So what happened since? Amgen’s earnings grew at an impressive annual rate of about 16% between 2000 and 2011, going from $1.06 per share to $5.32. That kind of tremendous earnings growth would likely make a “growth” portfolio manager happy. However, by the end of 2011, eleven years later, Amgen’s stock was still trading at $64 per share! The stock went virtually no where for the past eleven years while earnings “caught-up” to the stock by going from $1.06 to $5.32. Now, because the stock has done nothing while earnings have gone up 5-fold, the P/E ratio has shrunk back to 13 times last year’s earnings. The excess valuation of the 2000s has unwound and the stock again appears to potentially be a value. But whether it really is a value worth purchasing will depend on what happens to earnings going forward. This is the second part of the Growth at a Reasonable Price strategy.
Why Growth Matters
There are many stocks that trade at low P/E or price-to-book ratios and not all end up being good investments. The key is to avoid “value traps.” There are companies that trade at low valuations that end up being terrible investments because earnings are going in the wrong direction. For example, in 2007 the S&P financial sector traded at an average of 1.7 times book value and 12 times current year earnings. To some value managers, banks, REITs and other financial stocks appeared to be trading at attractively low valuations despite the fact that, by the end of 2007, it was increasingly clear that the housing market was deteriorating and that bad mortgage loans were going to be a problem. Sure enough, the sector went from a profit of 25.79 in 2007 to a loss of 2.18 in 2008. Stock prices for the sector fell 57% that year, far worse than the decline for the S&P 500. The lesson is that value has to be evaluated in the context of earnings growth—the two go hand-in-hand. Very often the key is finding stocks that are out of favor, perhaps because of past earnings weakness, but whose earnings are set to improve going forward. The combination of both low valuations and positive earnings surprises is nearly always a way for successful investing. In order to do so, we spend our time looking into company strategy, industry conditions, and business fundamentals of the companies in which we choose to invest.
Growth versus Value
As we already noted, value investing has outperformed growth styles over the long run, and in most periods. However, there are times when growth wins. Russell Investment ranks the performance of its five main value and growth indices each year. The last time a value index ranked at the top and a growth index ranked at the bottom was in 2008. In the three following years, and so far in 2012, a growth index came in first and a value index came in last. What has happened? Many investors have narrowed their focus to “growth” companies that are perceived as being able to increase profitability in virtually any market conditions. Clearly Apple has been the most successful in this group. But there have been others such as Amazon (P/E of 177) and Salesforce.com (P/E of 98) that have had great stock performance thanks largely to expanding valuations. However, as we saw in the Amgen case, valuations are like rubber bands that create tension as they expand. Sometimes a small disturbance can cause them to spring back.
Value Should Regain the Lead
We have argued that value investing makes the most sense on a theoretical level and that the data supports the theory since value has outperformed growth over the long run and over most periods. And, as we have argued, value is best when combined with a search for growth. But why should value soon again take the lead? As the valuation levels of the growth companies get more extreme, the chance of disappointment increases. Even the great Apple, which trades at 3.8 times sales, versus only 1.8 for the computer hardware industry and 1.2 for the S&P 500, will be at risk if competitors are able to develop competing products that put downward pressure on the company’s phenomenal net profit margins of about 24%. And, part of the mystery of investing is discerning the madness of crowds. The recent problems with the Facebook IPO and the subsequent poor performance of the stock could be an early warning sign that the growth stock phenomenon is nearing its end. We would not be surprised. Especially with the problems in both Europe and the US coming to a boil, a turning point could be at hand. From our perspective, the logic of value investing is solid and we will stay with what works over time and avoid the fads.
The FVCM Strategic Equity Portfolio (SEP) is managed according to a disciplined version of the valuebased strategy known as Growth at a Reasonable Price (GARP) that we developed in view of the best academic studies in the field of finance and investment management, as well as more than 25 years of practical experience. While this strategy is rooted deeply in the best theoretical and empirical evidence, there are sometimes lengthy periods when the strategy fails to deliver performance that we desire relative to the benchmark. This has been particularly true during times when “growth” or popular “trendy” stocks dominate for reasons sometimes more perceived than real. The market conditions that followed the financial panic and recession of 2008 have produced one such period. Nonetheless we are confident that the strategy remains sound and that there are increasing indications that the relative performance will again be positive.
H. Terrence Riley III, CFAF&V Capital Management, LLC
The information contained in this report is intended solely for the clients of F&V Capital Management, LLC in the United States, and may not be used or relied upon by any other person for any purpose. Such information is provided for informational purposes only and does not constitute a solicitation to buy or an offer to sell any securities under the Securities Act of 1933, as amended, or under any other U.S. federal or state securities laws, rules or regulations. Investments in securities discussed herein may be unsuitable for investors, depending on their specific investment objectives, risk tolerance and financial position.
The information is obtained from specified sources and is believed to be reliable, but that accuracy is not guaranteed. Any opinions contained herein reflect F&V´s judgment as of the original date of publication, without regard to the date on which you may receive such information, and are subject to change without notice. F&V may have issued other reports that are inconsistent with, and reach different conclusions from, the information presented in this report. Those reports reflect the different assumptions, views and analytical methods of the analysts who prepared them. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance.
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