Why Value Investing Works for All Stock Categories

2019-09-25

Introduction

I would like to credit my good friend Jeff Miller for providing the inspiration for this article.  In his recent article titled “Weighing The Week Ahead: Falling Confidence A Possible Threat To Markets”  he suggested a must read article by Safal Niveshak titled “Why Value Investing Works.”

From my perspective, although Safal Niveshak’s article was both short and succinct (reading time 4 minutes) it was jampacked with profound long-term value investing wisdom.  Therefore, if you care at all about your long-term investing success, please take the few minutes necessary to read and contemplate this important work.

In other words, I would like to echo Jeff’s recommendation because it really does justice to one of the most profoundly successful investment strategies followed by and recommended by the most highly recognized investment greats of our time.  Of course, I’m referring to investing legends Ben Graham, Warren Buffett, Phil Fisher, Peter Lynch and Joel Greenblatt to name just a few.

Excerpts from: “Why Value Investing Works”

Why Value Investing Works starts out by sharing a quote essentially attributed to Joel Greenblatt as follows:

“Jack Schwager, the author of Market Wizards series, when answering a question on whether value investing works, turned to the wisdom of Joel Greenblatt, one of the foremost experts on the subject.

Schwager quoted this from his interview with Greenblatt –

Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term, which sometimes can be as long as two or three years, there are periods when it doesn’t work. And that is a very good thing.

The fact that the value approach doesn’t work over periods of time is precisely the reason why it continues to work over the long term.

From my own personal experience, I have found that the hardest aspect of being a successful value investor is the willingness to recognize that markets often misappraise stocks in the short run.  In simpler terms, at any point in time, the market can and will overvalue or undervalue a given company’s stock without regard to fundamental values.  As a result, these same investors lack the confidence to trust that fundamentals will inevitably rule over the long run.  From the article, Joel Greenblatt had this to say:

It is very difficult to follow a value approach unless you have sufficient confidence in it. In my books and in my classes, I spend a lot of time trying to get people to understand that in aggregate we are buying above-average companies at below-average prices. If that approach makes sense to you, then you will have the confidence to stick with the strategy over the long-term, even when it’s not working. You will give it a chance to work. But the only way you will stick with something that is not working is by understanding what you are doing.”

The article then went on to conclude and summarize its message by simply pointing out that most unsuccessful value investors fail because they lack the patience to commit to long-term holding periods of time.  I agree with that assessment and have personally experienced people behaving that way many times over my five decades in the industry.

Once again, I agree with the conclusions that the article presented.  However, even though I thought the article was profound in its wisdom, I did feel like it fell short in answering the question suggested in the title of the article.  Therefore, I would like to add my contribution by expanding more on the actual “why” that value investing works.  I especially want to expand on the closing idea that was presented as follows, emphasis added is mine: “All in all, Greenblatt’s simple idea is so insightful.  Value investing works (over the long-term) because it sometimes does not work (in the short term).” 

Attractive Value Applies To All Categories Of Stocks

In order to get started, I want to emphatically point out that there is no such thing as so-called “value stocks” versus “growth stocks.”  All stocks, even extremely powerful fast-growing companies can be undervalued or overvalued by the market.  Consequently, even though a business is growing at a very rapid rate, it can still be undervalued based on fundamentals over a short period of time, and therefore, it then becomes a value stock.  Valuation is a function of a company’s earnings and/or cash flows past, present and future.

Moreover, value is relative to how fast those earnings and/or cash flows grow past, present and future.  This is the essence of discounted cash flow analysis which, in my humble opinion, is the most relevant methodology of valuing a business.  All businesses, and all investments for that matter, receive their value from the amount of earnings and/or cash flows that it generates on its stakeholder’s behalf. 

This will be true when you analyze historical values and will thus be true when you are capable of accurately estimating future earnings and/or cash flows.  However, please note that past values can be different from present values and certainly future values.  It all depends on how fast those earnings and/or cash flows continue to grow.  As a result, you can learn from the past, but you must also realize that you can only invest in the future-and the future may be entirely different than the past.

Furthermore, the value of most anything is a function of finding something that you would like to purchase at a bargain price (value).  Stated differently, when you can find something at a bargain, you are receiving more value from it than you spent to purchase it.  This is true when buying merchandise, and it’s also true when buying investments.  The good news is that when you can purchase an investment at a bargain, you get the opportunity to make excess returns at minimal risk.  Nevertheless, my job with this article is to help you understand precisely “why” that is true.

However, before I move on, I would like to emphasize that there is one thing that I disagreed with relating to the quotes by Joel Greenblatt.  The idea that the short run only spans two or three years is often a gross understatement.  Markets can and often do irrationally value a stock over timeframes that exceed two or three years.  It is during these times when a person’s patience really gets tested.  Consequently, the only way that you can truly navigate through an aberrantly long period of market irrational behavior is to truly understand what valuation is, where it comes from and why it will inevitably prevail.  Simply stated, the answer lies in the numbers, or more precisely stated, in running the numbers through to their logical conclusions.

The Top Line Ultimately Drives the Bottom Line

Investors both professional and lay alike can easily become confused by financial jargon and complex definitions of metrics such as adjusted earnings, diluted (GAAP) earnings, basic earnings, owners’ earnings, operating cash flow, free cash flow, net changes in cash, EBITDA, enterprise value, etc. These metrics – and many others -are quite useful when conducting comprehensive and/or sophisticated financial analysis.  However, as the old saying goes: “the devil is in the details.”

Consequently, I believe that many investors get so caught up in the details and the semantics associated with these various metrics that they lose sight of the essence of what they really mean.  At their core, fundamental metrics are measuring sticks or instruments that provide insights into the inner workings of the business.  As a result, and as previously stated, they can be quite useful when conducting sophisticated financial analysis.  On the other hand, they can also cloud our judgment when we get too caught up in the minutia associated with them.

Therefore, the key is to simplify, simplify, simplify.  Intuitively, I believe that all of us understand and can recognize a successful business over one that is unsuccessful.  In other words, most people can identify a bad business from a good business.  Although bottom-line profitability (earnings) are a widely accepted and ubiquitously applied method of valuing a business, it always starts with – and in the long run – relates to the top line.  If the top line is weak, then all the financial engineering in the world can’t hide the weakness forever.

Therefore, to illustrate the essence of value investing I will utilize what is rapidly becoming my favorite fundamental metric – EBITDA.  Earnings before interest, taxes, depreciation and amortization (EBITDA) is essentially a metric before standard financial engineering is applied.  Consequently, it is closer to cash flow than it is earnings.  Nevertheless, my point is that it is a metric that provides a good insight and even feel into and for how strong the underlying business truly is.

Value Investing Works When the Business Is Creating Value

The essential principle that I am attempting to convey is that value investing only works when the underlying business is creating value.  In other words, cheap and value are not always the same.  This is precisely why solely relying on metrics such as P/E ratios or any other multiple of any other fundamental metric can be dangerous and misleading.  Therefore, allow me to offer two examples, one unsuccessful and one successful utilizing the most widely utilized metric for valuing a stock – the P/E ratio.

For example, on December 30, 2011 Avon Products (AVP) closed the day at a very low P/E ratio of 10.65.  At first glance, most investors would consider a P/E ratio under 11 to represent a very low valuation.  However, had you purchased Avon Products on that day and held it through yesterday’s close you would have lost approximately 74% of your principal.  Even when you add in dividends, which were eliminated in 2016, your total loss was over 65%, or -12.8% annualized.  To be crystal clear, that is not what value investing is all about.

In contrast, had you purchased Lockheed Martin on December 30, 2011, its P/E ratio was even lower at 10.31.  In this case, if you purchased it on that day and held it through yesterday’s close, you would have nearly four times as much money and your annualized rate of return would have averaged a positive 24.4 % per annum – a great total return.  That is what value investing is about.

The difference between the two, and the key to not only understanding but also in having the patience is to trust that value investing relates to how the businesses performed post December 30, 2011.  Avon products ended 2012 with $1.64 worth of operating earnings per share.  By year-end 2018 operating earnings fell to a mere $0.03 per share and is expected to be only $0.18 per share by year-end 2019.

In contrast, Lockheed Martin ended 2011 with $7.85 of operating earnings per share that grew to $17.59 of operating earnings per share by year-end 2018 and is expected to generate $21.14 a share of operating earnings in 2019.  Although both companies were available at similar and very low P/E ratios at the end of 2011, Avon Products’ business collapsed while Lockheed Martin’s business grew at double-digit rates.

This takes me back to the significance of the Joel Greenblatt quote referenced above as follows with my emphasis added:

It is very difficult to follow a value approach unless you have sufficient confidence in it. In my books and in my classes, I spend a lot of time trying to get people to understand that in aggregate we are buying above-average companies at below-average prices. If that approach makes sense to you, then you will have the confidence to stick with the strategy over the long-term, even when it’s not working. You will give it a chance to work. But the only way you will stick with something that is not working is by understanding what you are doing.”

True value investing implies investing in above-average companies at below-average valuations.  When you do this, all you need to do to succeed is to continuously evaluate each company’s quarterly financial report with the objective of determining whether the company is growing or not.  However, as a cautionary note, one bad quarter will not destroy your thesis if the long-term business fundamentals remain intact.  Moreover, a small or insignificant earnings miss by a few pennies or revenue misses by a few million dollars will generally not alter the long-term view.

Furthermore, I would like to make sure that the reader has the proper focus.  The examples I presented above, and the performance calculations, were made utilizing price action over the timeframes measured.  However, the key and the essence of value investing lies in the fundamental performance of the underlying business.

Therefore, I offer the following additional graphs where I calculate performance based on the fair fundamental value of each company.  The reader should also note that based on price action, both examples are currently technically overvalued based on fundamentals.  Hopefully, this will provide an additional insight into what value investing is truly all about.  It’s about the business value, not the price.  The bad business still produces terrible results based on intrinsic value calculations, while the good business still produces extraordinary results based on intrinsic value calculations.

Why Value Investing Works: FAST Graphs Analyze Out Loud Video utilizing EBITDA

Although I’ve attempted to present the essence of why value investing works with words and a few examples thus far, a picture is worth a thousand words and, therefore, a video worth many more.  Consequently, with this video I will run through several widely-recognized and widely-followed common stocks utilizing only the metric EBITDA.

As I stated previously, this specific metric provides insights into how well the underlying business is performing prior to the numbers becoming contaminated by accounting convention.  As a result, I believe that it will provide great insight into why value investing works and how it works.

You won’t want to miss this video where I will be covering the following high-profile stocks:

Apple (AAPL), Amazon (AMZN), Ascena (ASNA), Broadcom Inc (AVGO), Caterpillar (CAT), Cigna Corp (CI), Cisco Systems (CSCO), Centurylink (CTL), CVS Health (CVS), Ford (F), Facebook (FB), Alphabet (GOOGL), Hershey (HSY) Johnson & Johnson (JNJ), Lockheed Martin (LMT), 3M Corp (MMM), Realty Income (O), PepsiCo (PEP), Proctor & Gamble (PG), Starbucks (SBUX), Southern Co (SO), Visa (V)

Summary and Conclusions

Warren Buffett has taught us that “investing is most intelligent when it is most businesslike.”  This truly is the essence to value investing.  As indicated earlier, value investing works precisely because sometimes it doesn’t work.  When it isn’t working are the times when true value manifests.  However, as I also indicated earlier, it takes the exercising of great patience.  But as Joel Greenblatt taught, value investing only works when you understand what you are doing.  Therefore, the key is to both understand and focus on business results instead of reacting to price action.  Consequently, I call it applying intelligent patience, because you know what you are doing, and that is simply investing in above-average businesses at below-average valuations.

Disclosure:  Long AAPL,AVGO,CI,CSCO,CVS,F,FB,GOOGL,JNJ,MMM,PEP,PG,SO,V

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Category: Research Articles

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