Those Calling for the Death of Value Investing Are Wrong

Includes: BRK.A, BRK.B, JCOM, SPY
by: Jonas Elmerraji

“The Death of Buy and Hold” flashes on the screen on CNBC…

Normally, seeing editorialized headlines touting the end for value investors on financial TV wouldn’t be a shock – but that latest television segment is just the last nail in the coffin for an investing strategy that’s been taking a lot of heat in the past year.

“I just don’t think that [buy and hold] is a wealth building strategy any longer,” says a major financial blogger. “These days, value as an investing strategy is dead,” says another.

Clearly buy and hold bashing is the cool thing to do in 2009. But is it true? Are buy and hold and value investors dinosaurs who’ll be relegated to losses this year? Not a chance.

The anti-value crowd’s favorite argument is that value investing poster boys like Bill Miller and Warren Buffett had horrendous returns in 2008, so their strategies clearly can’t work that well.

And just look at the S&P 500 – if you invested money in the market 12 years ago, you’d be sitting on 0% returns right now. So much for long-term investing meaning gains.

But thankfully for investors, the value naysayers are dead wrong when it comes to the virtues of value investing. Before they run a buy and hold obituary, there are some things that we should clear up.

Where Were the Value Investors in 2007?

To say that value didn’t work for investors in 2008 means that investors had to take a value approach in the first place in 2007 and before. Just how valuable were stocks before the bottom fell out of the market? Here’s a look at historical P/Es of the S&P 500 every quarter since 1936:

The consensus is generally that the average P/E of the S&P 500 is around 10; it’s not. Since 1936, the S&P 500 has averaged 15.8.

But in late 2008 the S&P’s price to earnings ratio had risen to the mid 20s. In fact, they hadn’t touched that 15.8 average in 13 years. For the first two quarters of 2008 before stocks went into freefall, the S&P’s P/E ratio averaged just over 23… 45.5% higher than the historic average.

Now, there are a lot of reasons why the market should have a higher P/E than it has in the past – constituent companies have changed pretty dramatically in the last 73 years, for starters – but that still doesn’t explain why companies delivered investors with 39% less earnings bang for their buck between 2005 and 2008.

True, earnings aren’t everything, but companies weren’t offering more in terms of assets either. Price-to-book ratios for the S&P 500 more or less grew along with P/Es over this period (as explained in this article by Todd Sullivan), and outpaced their historic average by almost 30% at the outset of 2008.

The analysis may be quick and dirty, but the data suggests that the market was overvalued coming into last year.

Patience is a Virtue

Simply put, a buy and hold strategy consists of two parts: buy, and hold; it’s that second part that some people just don’t seem to get right now.

Investing for the long-term involves holding onto stocks for a while, and while the past 12 months have been painful for all investors, buy and hold as a strategy is going to take longer than a year to dispel.

The irony is that it’s the people who don’t have the patience to ride this storm out that are sounding the death knell for buy and hold investing.

That stocks haven’t made any money from a decade ago is a potentially damning fact for buy and hold investors, but that’s really not the case. Taking for granted that the S&P was overvalued for the majority of the past 10 years, and since large caps are part of the S&P 500, one place where value still might exist is the small-cap space.

And indeed, according to Morningstar, the average small-cap value fund produced annualized returns of more than 5% over the last 10 years. But that doesn’t prove that long-term value works in and of itself.

What’s more compelling is Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A). If there was ever a living example of value investing at work, the Oracle of Omaha is it. While shorter-term returns are almost as bad as the rest of the market, long-term investors have won out with the company’s stock – it has returned an average of 11% annually since 1996.

Emerging With Gains in the “New” Stock Market

That’s right… it’s still possible to make money in this “new” market as a buy and hold/value investor.

And I’m happy to speak firsthand about it; in the first quarter of 2009 the Rhino Stock Report’s subscribers booked average gains of 24% while the market was down almost 12%.

How? Well, let’s start by investing with these 4 axioms of value investing for this new market in mind:

1. The Business Disconnect
Right now there’s a huge disconnect between stocks and their underlying businesses. Solid companies that make money on a constant basis are trading for less than income. That’s insane.

As long as investors want to push down share prices of fundamentally good stocks we’ll happily buy them at the discount.

2. Wall Street is Reactionary
The stock market can’t help but be reactionary. Geithner does that, then the stock market does this. Job losses were this bad, so the stock market does that. It’s not the fact that the stock market is reactionary that’s bad for investors, it’s the fact that people refuse to acknowledge how predictable it is.

That predictability has been making skilled traders a mint in this market… and it’s been good to value investors who know when to suspend buy and hold in exchange for cash and carry.

3. Fundamentals Will Continue to Rule Technicals
Yes, it’s simplistic, but you can’t keep a good stock down. Fundamentals move the market, and as long as good stocks continue to do well returns will too. It doesn’t matter that the charts look ominous if a company announces stellar earnings or lifts its dividend. JCOM is a good example of that.

Remember, though, that this rule works in reverse too.

4. Selectivity is the Name of the Game
Even when the S&P’s overvalued, it doesn’t mean that each of its constituent stocks are, and it certainly doesn’t mean that good value plays don’t exist in the rest of the market. The trick is discerning which stocks should make your cut.

While that may seem like a simple suggestion, recent history suggests that it’s one that’s been overruled for a while now.

Value’s Back in a Big Way in 2009

To be clear, value isn’t the only way to make money in the stock market… far from it. There are scores of effective investment strategies out there, and there will be for as long as the financial markets exist. Still, value investing will be living strong for a long time to come.

While I’m sure that this article will elicit no shortage of dissenting opinions, the main takeaway is this: the failures of value investing aren’t to blame for the financial disaster that befell us in 2008, but the misapplication of value investing is partly responsible for the perma-bull attitude that lead up to it.

Here’s to more disciplined investing in 2009.

Disclosure: JCOM is a long position in the Rhino Stock Report’s portfolio.