Why I’m all about value

Investing in glamorous stocks generates lousy returns; investing in out-of-favor, unloved and even hated stocks generates great returns. And, that’s why I’m all about value.

The return from investing in stocks can be roughly broken into two parts: 1) how a company does, which is what almost everyone focuses on, and 2) investors’ general attitude toward a company.

Most investors, whether individual or professional, focus almost exclusively on #1. They look at growth, sales, profit margins, competitive positioning, return on capital, new products, distribution, marketing, etc. Don’t get me wrong, this is vitally important stuff. But, it’s only half the picture.

Just as important is investor perception. When a company is loathed, its price reflects that fact. People sell investments they loath. They don’t want to talk about such investments at cocktail parties. Most of all, they don’t want to try to explain why they’ve bought something unpopular.  

When a company is loved, its price reflects that fact, too. People buy investments they love. They’re excited to talk about such investments at Christmas parties and how they are going to make a fortune. With these investments, people enjoy explaining why they bought it, and how much money they’ve already made (sometimes including all the relevant facts).

But, loved companies aren’t as good investments as those that are loathed. The reason is simple: it’s in the math.

Loved companies sell at a high price relative to underlying fundamentals. All those people who love a company buy it, and that drives its price up. Loathed companies sell at low prices to underlying fundamentals. Everyone who hates it sells it, and its price reflects that.

If all that mattered were the fundamentals, then loved companies would almost always out-perform loathed companies. But the math of returns reflects both fundamentals and the price paid for those fundamentals.

Perhaps a theoretical example will better illustrate my point. Say two companies, Loved and Loathed, both make $1 per share in earnings.  

Loved is growing at 15% per year. Because everyone loves Loved, they pay a high price for it: $30 per share, or 30 times earnings (this is not unusual, Apple sells at 15x, Google at 20x, and Amazon at over 100x!).  

Loathed, on the other hand, isn’t growing at all. Because everyone loathes Loathed, it sells at a very low price, or 5 times earnings (think Merck after Vioxx, or BP after Mecando).  

Now, what happens going forward?  

Even supposing Loved can maintain 15% growth for five years, people eventually become less excited about it. They know such high growth can’t last forever, and a fad eventually becomes boring to those excited about the newest thing. As the saying goes, ardour cools.  Instead of being willing to pay 30 times earnings, investors are only willing to pay 20 times earnings (still a very generous premium). Over five years, earnings per share will have doubled, but stock price will only go up 33% ($2 earnings per share times 20, $40 on a $30 investment is a 33% return).

Loathed, on the other hand, continues to be a dog. It doesn’t grow at all over the following five years. In contrast to Loved, everyone who hates Loathed has already sold it and gets bored with hating it over the following five years. When investors become surprised that Loathed doesn’t go out of business, the price starts to recover. Although Loathed earns the same $1 per share it did 5 years earlier, people are eventually willing to pay 10 times earnings for a no-growth business. Over five years, Loathed returns 100% ($1 earnings per share times 10, $10 on a $5 investment is a 100% return).

My example above may seem contrived, but that’s how things really work out. There are countless research papers from Fama and French, to James Montier, to David Dreman supporting my contention. Or look at the investment records of Warren Buffett, Walter Schloss, Robert Rodriguez, O. Mason Hawkins and Wally Weitz.  

If you think this is a smooth ride, think again. It’s no fun owning Loathed. People will think you’re nuts (believe me, I know). Almost no one will want to talk to you about investing–especially at cocktail or Christmas parties. But, it pays very well.  

Making this approach even tougher, investing in value goes out of favor for long periods of time, too. Value grossly under-performed from 1995 to 2000, before dramatically out-performing from 2000-2005. Value has gain been out of favor over the last six years. C’est la vie!

It may look ugly, be unpopular, and under-perform for long periods, but value investing works by capitalizing on investor perception. That’s why I’m all about value. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Why I’m all about value

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