Bill Mann offers a contrarian look at "value investing."
“When art critics get together they talk about form and structure and meaning. When artists get together they talk about where you can get cheap turpentine.”
– Pablo Picasso
Dear Fellow Fool Funds Shareholder:
In 2008, when we wrote our prospectus for the Motley Fool Independence Fund, I insisted on using the term “value investors” to describe our process. This was important to me – I wanted people to understand how we thought about companies, and what we were trying to do. “Value” was a great word, as it meant, at its core, that we were looking for mispriced assets.
Or at least this is what I thought.
We spent a lot of time over the next few years talking with investors who would ask, invariably, some form of this question: “How can you call yourselves value investors when Morningstar/Lipper says you are growth?” or “How can you say you’re a value investor and still own Under Armour at (insert whatever P/E) times earnings?”
What I discovered was that “value” in the world of professional investing is more of a term of art than it is a way of thinking or a philosophic underpinning. Unless you’re Warren Buffett or Bill Miller, you just can’t buy companies that look expensive or involve change-the-world tech and call yourself a “value guy.” To the investing community, this description just doesn’t compute.
(Note: "P/E" alludes to the price-to-earnings ratio. Generally speaking, a company's P/E ratio is defined as its stock price divided by its earnings per share.)
Time to reassess?
Folks who know me personally know that I can be a little stubborn. After all, I once defied everyone’s wishes to attend a shareholder party after spending the night in the emergency room. So I’ve struggled a good bit to reconcile how we think of “value” with how the industry has traditionally viewed it. I’d like to explain some of my thinking here.
Ironically, now would be a good time to wonder why someone would want to identify as a traditional “value investor” anyway. After all, over the past few years the returns of the growth component of the S&P 500 have been substantially higher than those of the value component. Why should I want to identify with something that has done so poorly? Don’t I like winners? And why would I want to buy banks and rock companies and utilities, anyway? Haven’t I heard about this crazy World Wide Web phenomenon? In short…the heck is wrong with me?
I think that very concept that value might be dead, though, comes from a basic misapprehension of what “value” is. In short, while people seem to focus on certain industries as being “value” and others being “growth,” for all practical matters there is no such thing as a value company. Value, instead, is merely a function of the price you pay versus how much it is worth. At some price, every company is a value, while at another price it is a speculation.
So, of course my team and I have heard of the internet. We have plenty of exposure to companies like Splunk (no P/E) and Ultimate Software (P/E north of 300) as our bona fides in this regard, and we hold them with no sense of irony at all. We believe these companies’ share prices offer a sufficient margin of safety.
And we believe this despite something else we believe: Both the U.S. stock market and the bond market are quite expensively priced. An expensive market places significant demand on our investment discipline: After all, there is no ironclad law that states that something that is expensive will revert on anyone’s schedule. Things can remain expensive for a long, long time, which mean that those who have structured themselves in a defensive manner can look foolish for a long, long time.
Why utilities aren’t value stocks
As of the beginning of October, the two best-performing sectors of the S&P 500 year to date are energy and utilities. Energy’s performance makes sense given the depths of despair it saw in 2015, but utilities? Aren’t those supposed to be traditional “value stocks?” What’s going on there?
Have you heard of the acronym TINA? It stands for “there is no alternative,” and I believe it’s driving some of the rise in utilities. They’ve grown expensive as investors have despaired of getting much yield from fixed-income securities. Investors, seeking some safety, have no choice but to push into these stocks because of the ultra-low interest-rate environment. As an industry, utilities yield the most and are least vulnerable to operational shock. The demand for them has made them more expensive.
As a result, utilities – the poster children for traditional “value stocks” – aren’t at the moment actual value stocks on a statistical basis, nor do we believe that their shares offer a sufficient margin of safety. And if utilities aren’t value stocks at the moment, what on Earth is? And if the answer is “very little,” where does that leave us?
Here’s where I think the Fool Funds view on “value” is more helpful. We don’t view value investing as just a mechanical process to find “cheap stocks.” It’s actually a commitment to perform in-depth fundamental analysis on what we think are high-quality companies, and to determine whether the current prices of their stocks offer sufficient margins of safety. We at Fool Funds don’t believe that doing such an analysis is the only way to achieve market success, but it’s the way that makes sense to us.
Here’s why: Neither we nor anyone else really knows what the future holds. When you buy a stock, no matter what, you’re exposing the money you invest to risk. Maybe the company is secretly bilking customers by signing them up for accounts they don’t need (allegedly). Maybe a big announced merger is suddenly put at risk because the acquiring partner is being pursued, in secret by an even larger company. Maybe teens will suddenly, en masse, decide that they no longer like gigantic logos on their apparel. Maybe some doofus employee will show up to work and prepare food even though he or she has norovirus and get a lot of people sick.
We can’t know, so we adjust by trying to buy our companies at a discount to give us some added protection when things don’t go as we’d hoped. With companies, this happens an awful lot. And it can happen to a company regardless of P/E or other traditional growth or value marker.
The U.S. stock markets have enjoyed a spectacular rise since the depths of the market panic in 2009 – which we should celebrate but recognize that the result is that it hasn’t taken a great deal of discipline to generate gains, and conversely plenty of behavior that by all rights should have generated loss has received fairly benign treatment. And why not? When losses seem remote, why worry about them?
Is this dangerous? Can’t tell, but it sure is fun.
Well, why indeed. But bear this in mind: While it may seem as if stock market movements are a barometer for the performance of the underlying companies, it is also at its core a barometer for the human propensity to allow our logic signals to be influenced by fear and greed.
We’re looking very hard for stocks to buy, but it is a challenge. Some are calling the bond market a bubble resembling the dot-com disaster of 1999. I don’t know about that. What I do know is that we don’t come to work every day worrying about what the market will do – our approach is focused solely around the beautiful question of what we think a high-quality company is worth and whether the market is giving us a discount to that amount.
I don’t know if that meets the traditional definition of “value” or “growth” or “blend” or something else. But I do know that it’s what we practice here. And we do it that way because we believe it gives us the best shot to help preserve and grow your money.
As always, my team and I are humbled by your faith in us.