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

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:

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
22,6 6,4 4,1 2,8 16,4 3,5 1,6 2,7 3,2 4,5 -9,6 105,0 9,0 -20,9 -3,4 -36,6

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.

Summary/consequences

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.

23 comments

  • If focus on PE only, there is certainly a big chance that you might miss important aspects. PE is an accounting figure and can be influenced by one-off items, depreciation policy and financial engineering. A proper valuation goes a bit more in depth as you can see when using a more sophisticated valuation model.
    What you can do is to focus on key drivers which influence such valuation and assess how the current trends are going to impact the company’s EBITDA going forward.

  • gold mines are not gold proxies, they are loss proxies

  • We just do not know what strategy will outperform in the future.

    And we should embrace our limited knowledge about what works in investing and what does not.
    It will make us less confident, but more knowledgable and very likely more successful.

    http://undervaluedjapan.blogspot.de/2015/09/value-investing-and-virtue-of-not-being.html

    • I think that there are many strategies that will outperform. The trick is to stick with one for the long term…..

      • So you believe that many strategies will outperform. Only do you have to stick around with them for the long- run. So why do you believe that deep value investing is not one of them?
        It is a strategy that advocates thinking long- term!

  • Very good article (as always). Salzgitter was one of the first stocks I bought back in 2000 (for around 9 €) and always comes up as a prime example for my impatience (just see chart – I sold them in 2002).

    As a non-professional investor it’s really hard for me to find the time (next to the 8-10 hours of ‘normal’ work) to become an expert in sectors or branches. But here I could/can rely on you for nice introductions (e.g. Romania) :-).

    I often use screeners as a starting point and you’re right when you say that you often find companies that are cheap for a reason. But sometimes (out of luck?) you can find companies that made mistakes in the past but perform quite well afterwards. E.g. at the beginning of 2014 I found Heliad by screening for companies with negative Enterprise Value (=starting point). Of course I read their financial statements afterwards before buying, which was one of the reasons for not investing in Adler Real Estate at the beginning of 2013 or Adva Optical Networking at the beginning of this year… So I guess sometimes one can be wrong for the right reason – at least from a perfomance standpoint.

  • Thanks for your great post. I would like to “defend” mechanical value investing without deep research as a viable alternative to your approach. It is a pleasure to see that most of your readers consider the mechanical value approach as “naive”, i.e. not everybody will jump on this bandwagon.

    You are right with your observation that the “effectiveness” of individual factors (such as P/S) tends to vary over time. This is the reason, why many mechanics use a bundle of these factors, which has increased their effectiveness in academic studies. As you note, adding momentum as an additional facor will further improved the performance. The empirical evidence here is so clear that I would rule out data mining.

    As with your deep-analysis-approach, it is fundamental to understand, WHY mechanical factor investing works. The clue is that surprises have a different effect in cheap stocks and in expensive stocks. Cheap stocks with depressed expectations can only surprise in a positive way, whereas expensive stocks with high-flying expectations tend to surprise in a negative way. Ironically, you can not forecast an individual surprise – otherwise it would not be a surprise. But in a major portfolio of – say – 50 stocks, statistical chances are high that some of your stocks will experience a surprise from time to time. This is, why mechanical investing works.

    Might be that your approach offers a higher outperformance than mechanical investing, yet it also requires much more work ;o)

    Wishing you success, witchdream

    • Hey there,

      I feel the need to defend my statement regarding why these ratios are naive. As you say (and as I also mentioned in my comment), investing in stocks with high classical ratios (P/E, EV/EBIT, P/S, P/BV) is signficantly risker, which makes them more sensitive to any changes in the forecasts. But it still doesn’t mean that they will capture enough information about a company with regards to two essential factors: growth and risk.

      We probably agree on this: stocks with low ratios have a good chance of overperforming those with high ratios. However, I’m not fully convinced that these investment strategies can generate above-market returns for longer periods of time.

      Regarding how widespread these strategies are: I’m afraid they are more common than it might seem from the comments. Even I have studied them in detail for a few markets and even attempted such investment strategies for a while (to be fair, the result was quite satisfactory 🙂 ).

      • Hello Lucian,

        thanks four reply. I am happy to read that you, too, had “quite satisfactory” results with value factors. However, I don´t understand, why you gave up your successful strategy and why you focus now on growth and risk. As for growth, I have seen severals studies, which focused on a variety of growth factors (sales growth, profit growth etc), but none of these growth factors provided a significant outperformance. As for the elimination of risk, Gray & Carlisle (“Quantitative Value”, 2013) could improve the performance by applying Piotrosci´s F-Score, which is available in some screeners. However, the additional outperformance of the F-Score is rather weak, as compared to classical value factors.

        May I ask you, whih factors you apply to consider growth and risk?

        Cheers, witchdream

        • Hello,

          I didn’t necessarily give up the strategy, but now it’s just one of the factors used to select companies. The statement about growth and risk was about how these factors are not included when people compare ratios across companies. My portfolio is rather “value” oriented than growth oriented, I’m really not comfortable with the assumptions behind a lot of the growth companies.

          The current valuation method used depends on whether it’s an operational analysis, an asset play or a possible takeover target.

          For operational analysis (which means just buying companies for their operations), I use discounted cash flow, as well as a bit of relative valuation, especially using EV/EBIT. Using DCF is great because it forces you to think about the company’s growth, investment needs and riskiness, but it also involves a lot of guesswork, which makes such an analysis as good as its assumptions.
          For modeling a company’s growth, I highly recommend the Corporate Life Cycle model from Credit Suisse, which probably is a lot close to reality than the classical 2-stage DCF models. You can find it here: https://www.youtube.com/watch?v=L9Mzx5pdWwM (along their HOLT methodlogy, which is pretty neat).

          For asset plays it’s just about evaluating the market price of the assets (the more liquid, the easier) and then knowing what the sell schedule for the assets is. Then I discount the proceedings based on the timing of the sale with a higher discount rate than the one used for regular companies because of the risk associated.

          For takeover targets, using relative valuations and synergies with the buyer. Since estimating synergies is more of an art I’m not familiar with (and in my opinion it’s mostly just corporate talk to justify excessive acquisitions prices), these kinds of investments are extremely rare for me.

  • Hello,

    This post echoes a lot of my thoughts regarding stock picking using only stock screeners and basic ratios, such as P/E, P/BV etc.
    One of the issues I see with these ratios is that they don’t capture enough information about a company in order to make them comparable across companies (for instance, P/E does not capture growth and risk, which means that you can’t really compare companies based solely on it, not even if they are in the same industry).

    However, I do think they are a good filter when you want to weed out certain companies. While portfolios created only using these ratios might or might not beat the market, there’s a pretty high chance that they will perform better than portfolios made out of stocks with high ratios. This is primarily because stocks with high P/E (for instance) are probably high growth stocks, with a lot of optimistic assumptions built in.

    Like in any other domain, becoming a good investor takes a lot of studying, research and discipline. So yeah, thinking that you can beat the market by using a stock screener or a simple ratio is optimistic and naive.

    At the same time, there are a lot of areas of the market that are not too well covered by large, experienced investment companies. Some emerging markets, small-mid cap companies, industries that are temporarily out of favour (banking right now), global crises that really affect companies disproportionately, etc.
    Individual investors probably have a significant edge over institutional ones in these areas because they have no restrictions or a short-term performance objective.

    • Lucian,

      thanks for the comment. I agree, there are still relatively “undiscovered” sectors and markets out there (e.g. Romania). But in many of those cases you are actually earning a liquidity premium instead of a value premium.

      mmi

      • Yeah, I think it’s a mix of low liquidity and no analyst coverage (which often is also because of low liquidity). It’s amazing how many analysts pile on the extremely large companies, while a lot of medium and small cap companies have no coverage.

        For me, liquidity is not that much of an issue, as I’m willing to wait for months in order to buy or sell a stock. So the main risk is actually that of not understanding the underlying business rather than whether I will be able to sell my position in a few days/weeks.

        Anyways, forgot to tell you: goob job on yet another well-documented post!

  • Hi. Another great and thought provoking post. A few things:

    1) The market is often wise, but is also prone to strong and irrational fashions. If you can identify areas outside of these (like financials at the moment or small and mid stocks in general pre 2000) then low optical valuations are not a trap? Foresight is still hard, and maybe the difference between financials pre and post 2008 is just hindsight…ie we do not know why we should quite hate them yet. But with private and now government debt levels at high and “uncleansed” levels maybe the wisdom of the crowd is putting some of that in the price for financials.

    2) I agree that oil and miners are too raw still to spit out lots of survivor value and its macro to buy right now. I think oil is particularly problematic as too many people believe they understand oil and how to analyse these companies. I think this problem isn’t as acute in miners as I do not think generalists feel so expert there. I am inclined to think I should look at miners now for understanding but not buy yet. However, I have become interested in small cap gold miners. I am not a gold believer so not driven by that. I think I can find smaller cap miners that are optically cheap and in a position to maintain their earnings at current price levels in a way that large miners cannot (as they driven to invest and produce at the marginal price, so when price falls they need to clean up operations after them or sell) and grow them through operational factors and not the commodity price. I accept that I may be in the trap you state above and worry about that. The commodity may fall too of course but I do not think the market has insight on that other than generalised anxiety putting that in the price of the stocks. Any views on the sector? (I am anxious as I recognise that I am no expert in the sector)

    3) I sold EM in January 2010 and since then my only investment is Argentinian stocks (bit early as mid 2012) – I think a parallel should be drawn between Argentine stocks and Brazil in the 80s/90s (not the same bad politics but the same negative effect on quite long established businesses). To survive in those sort of markets as a business you must run it well as capital markets are closed to you and you must make sure there is more cash in the door than going out all the time or you go out of business. It also makes capital investment decisions very conservative. Argentina is perilously close to the edge in terms of political and economic problems right now and that makes it likely that next move is to move towards a footing that will see compromise with creditors. On general EM after this sell off I am interested again in broader EM. I think its probably a bit early still but I think the fear of Fed moves rather than the reality of it is now more a problem. Also, some crisis for countries or stocks will be beneficial as people can see what to fear. So I am going to start buying a little now. I don’t have time to pick the stocks right now so I will probably start to slowly buy some specialist ETFs. Question: Do you have any recommendation for where a private investor can get information on emerging markets (e.g., I am interested in the Brazilian small and mid cap space)?

    Thank you (apologies for long note)

    • Hi, thanks for the comment. With regard to gold miners: I have no opinion at all with regard to gold and gold miners. As the predominant use of gold is not induatrial, I find it hard to invest here.

      EM stocks/Brazil: I think the only chance is to get annual reports. I am not aware of any blogs etc.

      mmi

      • Thanks for your response. I realise I am on the fringes of respectability with gold and see some teasing higher up the comments. I do not buy as a gold proxy. Gold companies make a product that sells at a certain price and costs differing amounts for different companies to produce (the large ones tend to be compelled to go to the marginal price). Unfortunately the price of gold is hard to forecast (to put it succinctly, its a little bit mad…but seems to stick around). But then again the price of, say, oil or copper or pigs is quite hard to forecast too.

  • I fully agree with your post.

    Buying baskets of cheap stocks works due to the “power law” in returns- i.e., a few investments that come back do so well to pay for everything else!

    And also if it is cheap and you can see it- means, plenty of others have sniffed it and probably moved on..

    Best conditions are when there is a seller who is selling without looking at the price- however, in the past spin-offs exhibited such behavior, but now the cat is out of the bag and recent spin-offs haven’t worked so well..

    • #Dhawal,

      clearly “forced selling” situations are interesting. Yes,the spin-off outperformance seems to be over but there are still some opportunities out there like the sale of Government owned banking stakes.

      mmi

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