Q&A - Why the Time is Right for Value Investing
Kelly: John, with the stock market at an all-time high, with over 10 years of continued growth, and U.S. stocks and bonds selling for high prices, what opportunities are you seeing in the market?
John: That’s a really good question, it's particularly good because we are in this period where we've had the longest expansionary period in history and that's happened at the same time as we've had a tremendous run in the stock market, so the average annual return since March of 2009, which was the bottom of the market after the credit crisis, is double digits.
Kelly: So, it's a period of exuberance.
John: Yes. That was one of the best phrases ever from Alan Greenspan, Federal Reserve Chairman when he talked about irrational exuberance.
So you tend to see a little bit of irrational exuberance particularly in the later stages of economic expansion or a stock market boom, and the areas that tend to do well are the areas we call growth stocks.
Kelly: What are growth stocks and what type of companies are the stand-outs in that category?
John: Growth stocks by definition are stocks that have a high price relative to the value of the company; they're just more expensive. What we've seen in the last several late-cycle booms of the stock market is that they’ve tended to be companies that focus on technology, like Amazon.
Kelly: Amazon gets too much of my paycheck!
John: Right? I love Amazon. Amazon is one of the greatest companies in the last couple of decades. You know, we have a little tree downstairs on the second floor in the Baker Boyer building and we get to hang pieces of paper on it that say what we're grateful for, and one of them recently said, “Amazon.” It’s literally transforming the way we shop.
Kelly: What would we do without Prime?
John: Exactly. Amazon is transforming the way a lot of companies do business, posing a real competitive challenge to companies like Best Buy. So, Amazon’s expected earnings in the future are bright—or the earning stream it could potentially generate in the future is high. That's why Amazon stock has a high price but is there a price that is too high?
Kelly: Is that Greenspan’s irrational exuberance piece?
John: Yes, what we tend to see is people get overly excited about the future earning potential of those companies: the prices go too high, and effectively what happens is now these are companies where nothing can go wrong, there is no margin for error. You're paying top dollar for these very optimistic earnings streams but we all know that business doesn't go perfectly. The future is uncertain. These companies are not all going to drive earnings exactly the way that people think they are. There's going to be hiccups and some of those could even be regulatory hiccups.
Kelly: Like what?
John: I think one of the larger threats facing a lot of these big tech companies is there's a monopolistic character of the way they're doing business today. In the past, a lot of monopolistic tendencies or trends have gotten checked because consumers didn't like it. What’s interesting now is that the consumer is the product. These big tech companies are selling data about us. So, the regulatory challenge is likely to come in the form of issues around privacy and data usage.
Kelly: So, the current monopolist trend may not be history repeating, but maybe rhyming instead. So, what is happening in the rest of the market?
John: If you take the bottom half of the market, it is the value side of the equation. Those are companies where we're paying a price for stock that has a margin of safety built-in, so if everything we've estimated about that company doesn't go just right, we're still going to get a pretty good return based on the current price.
What we tend to see with value stocks is that at the same time growth stocks experience irrational exuberance there is irrational pessimism around value stocks, and they get over-discounted. These are the unloved stock.
John: There’s this old Warren Buffett saying which is, "Price is what you pay, value is what you get.”
Kelly: Can you unpack that saying for me?
John: Here’s an example: Coca-Cola is one of these stocks that they bottle their product and send it out all over the world and people just keep buying it, and drink it, and buy it and drink it. So the earnings are stable, right? But, the price goes all over the place. Why? That’s value vs. price. There are these moments when the price of Coke stock is way down, and yet lots of people are going to keep drinking Coke. Well, that seems like a really great time to buy Coke stock.
Kelly: So is there currently an opportunity with these over-discounted, unloved value stock?
John: Yes, the difference between the loved section of the market—growth stocks—and the relatively unloved, value stocks is really wide, which leads us to believe that half of the market is on sale. The key is that the spread between the two is so wide that the probability of having the outcome you want in the future from value stocks, is high.
This graph of the U.S. Market shows the growth portion of the market is at least twice as expensive as it normally is on a price to book basis (p/b).
(Graph courtesy of Dimensional Fund Advisors )
Kelly: Why is that?
John: The price of growth stocks is higher than value stocks because the earnings are going to be higher for this group of stocks, and that’s generally always the case. But, if we get to a point where that spread between the average price of a value stock and the average price of a growth stock is wide then the likelihood that you will see these value stocks rebound and give a return that's higher than growth stocks is high. Right now we are in something like the 95th percentile. This just means that if we looked at 100 moments in history with one being the smallest difference between the price growth and value, we are approaching the high 90s at this point. It is rare to see the difference between growth and value this wide. Historically this has been a good time to buy value.
Kelly: What happens to growth stocks if the market corrects or growth slows?
John: We saw a little glimpse of this in the fourth quarter of 2018 when the market corrected by double digits—value stood up to that far better than growth. With these high prices, it's kind of the bigger they are the harder they fall. Over time, what we've seen is that over any 10-year period, 84% of the time value strategies have beaten growth strategies.
Kelly: I’ve heard you say it is actually a “generational opportunity” to buy value stocks.
Fundamentally, if someone asked me what my job is as an investment manager I would say that it's to stack the odds in my client’s favor.
So I'm thinking about probabilities. When we're seeing wide spreads relative to history and the difference between value and growth is significant, it’s not a bad idea to start buying some of those unloved stocks. Does that mean the market will turn around next year? Nobody knows. But for a patient investor, it is looking like a really good time to bet on value. It might even be a generational opportunity—meaning it doesn’t come along very often that value stocks are discounted as much as they are right now.
Kelly: Of course, timing the market has uncertainty.
John: Absolutely. There is a really well-known asset manager that is the CEO of a firm called AQR, and he has a saying that basically is, “You can't time factors.” But then he says...“but if you're going to sin,” meaning if you're going to try and time factors, “only sin a little” meaning “maybe there are these moments where it's okay to take a little more exposure to value than you might otherwise,” and that’s when the difference is wide. Just recently, he wrote a paper and the title was Time to Sin.
Kelly: Wow. Love it. Now is the moment.
John: Yes. He's saying, "I'm telling you that you can't time factors, and I'm telling you now that if you're going to time factors, now is the time.”
Kelly: It’s a generational opportunity. What about international value stock? Is there opportunity there?
John: So we can look at prices in the market as a whole, or we can look geographically and we can look at value versus growth. In all of those markets, value looks particularly attractive, but if we look at the world through a geographic lens and we say, “What’s the price differential between U.S. stocks and international stocks?” Generally, we're also at one of those moments where there's a kind of generational opportunity to buy international stock at a discount relative to U.S. stock and relative to its own history. So, international stock today looks cheap compared to the US, and it looks cheap relative to where it's traded in history.
This graph shows that right now the growth portion of the market is nearly several times more expensive than normal, on a price to book basis (p/b).
(Graph courtesy of Dimensional Fund Advisors )
Kelly: How does the current strength of U.S. currency play in?
John: Well, whenever the dollar is strong, then the emerging market currencies are weak. They buy less in dollar terms, so everything gets more expensive for them, especially commodities. The conversations we had with folks back east who have all been in these markets for three decades, all of them are saying, “We just don't see a future where the U.S. dollar continues to meaningfully strengthen and it's very likely it will begin to weaken at some point,” and that has the opposite effect. So then, all of a sudden your foreign currency-based stocks translated into dollars get you more dollars and that’s in your return.
Kelly: So not only are value stocks discounted, right now the U.S. dollar has more buying power, which could set up an investor of international value stock for nice returns later if the dollar weakens. So if the price is right and the time is right, are there risks associated with buying value stocks?
John: Oh, always, right? Cheap assets can always get cheaper.
Kelly: So what does Baker Boyer bring to the table then in helping choose which value stocks might be less risky?
John: Well, I think the way to start the answer to that question is to say it's rare that a Baker Boyer portfolio manager will ever say that there's a zero probability of something. We're probability-based, so we are going to own a balanced portfolio—that’s principle number one. That’s why we still own growth stocks, even though we think value will outperform in the future.
If you looked at our portfolios 10 years ago, the equity in our stock portfolios was roughly 70% U.S. and 30% international. Today, they're roughly a little less than 60% U.S. with the rest in international.
So we're making changes at the margins, but we're not going overweight in international markets, so we're keeping a balanced approach. That's one of the things that I think is a core principle of what Baker Boyer does, we are going to nudge people's portfolios into these areas with higher expected returns. Now, are there risks to pursuing these kinds of areas that have lower valuations? The answer is yes. With value stocks, there are some value stocks that are cheap for a reason, the market is smart.
Kelly: John, buying value stock reminds me of buying a horse. When I see a good deal on a horse, I want an expert with me to help evaluate “why” the horse is selling for below market—is it really a good deal, or are the sellers masking an injury, or does the horse have serious behavioral issues that will put me in the hospital? It seems like there are similar risk assessment questions when buying value stock. Bottom line: Is this really a good deal or is there a reason this stock is on sale?
John: Exactly, when you're buying this thing that has a lower price than it should, does that make you suspicious? Will there be some value traps in that value bucket? Absolutely, there will be. Now, one way we can mitigate our exposure to those value traps is to make sure that we're focused on companies with higher quality relative to companies in the same sector industry that have lower quality. We do that by overweighting investments in companies that are more profitable on a relative basis. Profitability tends to be a proxy for quality. By doing that, I think we really reduce our exposure to potential value traps.
Sam: So it seems like part of your job is understanding what the research is on how value correlates with expected returns. It seems like the nuance is really important. Can you speak to your research process with that or the potential pitfalls of blindly going into value?
John: Right, and that's a great question. I think one of the things that really differentiates some investment managers from others is this question of execution, how do you go in and actually build and maintain these portfolios? It's important to talk a bit about the due diligence process. One of the things we're doing is we're really going out and doing in-person due diligence with some of the smartest investment managers in the field.
We do a tremendous amount of research upfront just reading from a conceptual standpoint or theoretical standpoint about how we approach these markets.
For example, right now our Investment Committee has on their plate, discussing the definition of value, and there are many, that we think will best capture the higher returns that value stocks will generate. That's one thing that we spend a lot of time looking at.
Kelly: So in conclusion, is our headline: Generational Opportunity to Buy Value Stock?
John: About this generational opportunity—and there is some excitement around it—it really takes a particular mindset and understanding of how markets work, and where returns come from to stick with a value strategy. I’ve had multiple conversations with members of endowment committees, as well as individuals, who are basically saying: Okay, how much longer, how much longer are we going to do this?”
Kelly: So really feeling the pain of under-performance while waiting for the strategy to kick in.
John: One of the reasons that a value strategy has been effective for a century, and we believe will continue to be effective, is precisely that it can require incredible patience and perseverance, things we humans are not very good at. When pain and dissatisfaction are at its highest, that tends to be a very good time for patient value investors. At the end of the day, a lot of value comes from a really good advisor who has the ability to counsel clients through periods of under-performance that lead to out-performance. I have to make sure my clients understand that this is a time when even though they're feeling a little less confident about these kinds of strategies, that tends to be exactly the time that you're about to get paid.