Value Investing Strategy: Cheap for a reason
Value investing is all about investing into stocks where the current price is “cheaper” than the underlying value.
The problem is clearly that although we know the price of the stock at any point in time, we can never be sure about the “true” value of a company as the future is uncertain.
So quite logically many value investors start searching for undervalued stocks within the group of “optically” cheap stocks. I often get emails like ” What do you think of stock xyz, it’s only trading at a P/E of 3 or P/B of 0,2 – isn’t this a great opportunity ?”. Isn’t it a great BARGAIN ?
These days, getting access to a screening tool is easy so you can get quickly a nice list of really “cheap” stocks.
The main problem with this approach is the following: Especially in a market environment like now, cheap stocks are cheap for a reason. It is very unlikely that “you” are the first and only one who knows how to run a screener and by chance you are the only one who can buy this great company at 3 times earnings which will quadruple within 6 months.
Every “cheap” stock you will find has problems. Some of those problems might be individual (bad management, too much debt etc.), some of those problems might be more sector specific (oil&gas, emerging markets exposure) or a combination of both.
The most important thing is to be really aware what the real problem is. If you don’t find the problem, then the chance is very high that you are missing something.
If you have identified the problem then the next step is to ask yourself: Why do I have a different and better informed opinion than anyone else ?
Only if you can answer this question with a very specific answer one should start to consider investing into such companies.
But what about “empirical evidence” ?
There are a lot of empirical studies that over the long-term “cheap stocks” outperform expensive stocks (Graham, O’shaughnessey, Magic formula Magic sixes et al). So one could argue: Why should I do deep research ? I just buy a few of them and things will turn out right over the long-term. There are however several problems there:
– the results are almost always based on portfolios of many stocks
– over time some factors seem to lose their relevance such as P/E and P/B
– currently “effective factors” like EV/EBIT might again lose relevance in the future
So the chances to outperform by buying a few “cheap” stocks based on P/E or P/B without really deep research is in my opinion is very low. I cannot prove it statistically, but in my experience the out performance of “really cheap” stocks is driven by very few stocks. A lot of the cheapies turn out to be value traps and the performance is driven by the few recoveries. Either you do it systematically or you need to do it “deeply”. Anything in between is difficult. Newer research seem to compensate this effect by adding “momentum” into the factor set but I am not sure if this is data mining or a really consistent factor. And as many experts in modelling know: The more “factors” you add the more instable such models become.
What has worked for me
I do buy cheap stocks sometimes, but less so in the past. Buying cheap stock has worked for me best in the following situations
+ bad sentiment for whole country / region (BRIC)
+ after a “real crash” when everything is cheap
+ complicated situations (AIRE, Draeger)
+ forgotten/ignored companies/sectors
What I found difficult:
Bad governance could mean many things, either dominating shareholders who have different priorities or management with incentives that are not aligned with investors. Or difficult jurisdictions or a combination of all that. My major advice here is: No, you are most likely not the next Carl Icahn. I often here the comment: I will buy some stocks and then put pressure on management etc. But believe me: You are not the first and only and “activist investing” is not as easy as it looks like.
Weak balance sheets
Weak balance sheets are also a major issue to avoid. A weak balance sheet could either mean a lot of debt or other less obvious stuff like pensions or operating leases etc. Yes, there are some exceptions but if you are not a credit specialist, you should avoid those companies as a principle.
Terminal declines (sector, countries)
Those are the typical value trap: A sector which looked good in the past but is in terminal decline. The stock will always look cheap on a historical basis but mean reversion never happens. Current examples are for instance German utilities or many media companies. The same can apply for countries as well. Venezuela and Argentina are two examples where politics became so hostile that shareholders just never make any money. Greece in my opinion has all chances to join this club.
Capital intensive sectors / long investment cycles
In many capital-intensive sectors, there is always the same pattern: The industry is met with strong demand. Prices increase and profits multiply as additional capacity needs a long time to be created. However after some periods, the capacity hits the markets, prices decline and stay low for a long period of time. In most of such industries (e.g. Cement, Mining, Oil) P/Es are always lowest just before prices fall. This is for instance the stock chart of Salzgitter, a German steel company:
And those are the historic P/Es on an annual basis:
Buying Salzgitter in 2006-2008 at a low single digit P/E was obviously not a very good idea. Even buying it the years before would have resulted in below DAX performance over the whole period, unless you were smart enough to get out in 2007/2008. This is just one example for such a capital intensive business where low P/Es say absolutely nothing.
Sometimes the market is smarter than we think
That brings me to another point. Yes, “Mr. Market” is sometimes “manic-depressive” and valuations can deviate a lot from fair values. But often, if a whole sector looks cheap (especially without any market panic), then more often than not the market “knows something”. For instance, before the financial crisis hit in 2008, bank stocks were one of the cheapies stocks. Or oil companies have been cheap for a long time now and looked like a “No brainer” as everyone assumed that oil prices can only go up. Now we can clearly see that those low valuations were justified but to me it seems that the market “knew something”.
So be careful if a whole sector looks cheap and like a “no brainer”. There are no “no brainers” in a normal market environment.
One of the consequences for me is that I actually don’t use traditional screeners anymore for finding ideas these days. You end up wasting too much time on bad companies, although you learn always something if you analyze companies.
I find it much easier to do the analysis top down: Look for beaten down sectors/industries/countries and then try to find the best companies. Usually they are “kind of cheap”, not super cheap from a pure ratio basis. But often they are very cheap from a value basis. In almost all cases there is no hurry in identifying good investments. Recoveries are often not V-shaped and more often than not, stocks will first look expensive (i.e. have high or even negative P/Es) before the cycle turns.
Actually, I strongly prefer “forgotten” sectors compared to those which just have recently started to decline. Yes, everyone is looking at oil companies these days as they have declined a lot in the last months and look cheap. But I actually find better value in banks or financial companies. Everyone hates or ignores them which, in my experience is a much more fertile hunting ground than for instance oil or natural resource stocks.