Why A Deep Value Strategy Does Not Appear Optimal At This Time

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Summary

Value investors are taught to sacrifice growth opportunities for the sake of value.

There are times, like the turn of the century, when this was a good idea.

Now is not one of those times because you can buy growth along with value.

I have been a deep value investor for much of my career. In fact, I published a book on deep value investing, "A Modern Approach to Graham and Dodd Investing" (Wiley, 2004) in the middle of a decade (2000-2009) when it served me well. That said, I also recognize the limitations of that strategy, and realize that it doesn't work all the time. More to the point, "now" appears to be one of those times.

A deep value investor looks for the cheapest stocks of companies that are not obvious distress or bankruptcy candidates. In some cases, Ben Graham among them, the investor will look for stocks of distressed companies that s/he thinks will survive. Let's say that this investor has done a good job, and that the companies in the portfolio don't go under. Then the risk is that the cheap "deep value" investments will be "dead money," because of mediocre (but not terrible) fundamentals.

There are times when the prospect of "dead money" is by no means the worst thing in the world. One of these times was around the turn of the century, when the dictum of "growth at a reasonable price" turned into "growth at any price." That's when tech stocks went to stratospheric P/E multiples, above 50 or even 100, taking up a number of blue chip "Nifty-fifty" stocks up with them.

The growth was there, but the story was TOO well known. Basically, the growth stocks were saying that earnings growth would be higher than had been the case in all of US history. When this proved not to be true, it was soon reflected in a rare instance where the (mostly tech) stocks rated 1 (Highest) by Value Line, on "fundamentals," (mostly growth, actually), underperformed other stocks not so highly rated.

This occurred because these stocks were bid up to levels supported only by 2010 earnings. As well as the companies did, their earnings growth couldn't further push up stock prices that were already "too high." While this wasn't true across the board, it afflicted large segments of the market. The result was a "lost" decade for a majority of stocks.

At the beginning of this period, the choice was between cheap, mediocre companies priced on 2000 earnings, and good but expensive companies priced on 2010 earnings. Another sign of this fact was that average dividend yields went to historic lows, below 2%. In a "no capital gains" environment like the one that prevailed over that decade, which stocks were likely to beat the market on a total return basis? To many investors' surprise, it was high-yielding stocks in pedestrian industries like utilities, where "capital gains" more or less kept up with inflation, but the "real" total return was provided by dividends. Also in this category, but performing even better, were high yielding REITs (real estate investment trusts), and MLPs (Master Limited Partnerships) in energy transmission, that were unregulated utilities.

That was because during this period, many stocks behaved much like bonds. The Fed deliberately kept interest rates low, so that the sub-2% yield on stocks was reasonably competitive with bond yields, thereby more or less maintaining their value over the ten-year period. Meanwhile, the high-yielders "tightened" relative to the market, meaning that these stocks went up as the yields converged downward to those of other securities.

Even Berkshire Hathaway (NYSE:BRK.A) was caught up in the euphoria. In 2004, Warren Buffett ruefully admitted that he had made a mistake not selling high-priced blue chip stocks (probably Coke (NYSE:KO) and Gillette, among others) during the "Great Bubble of 1999." While I scrupulously avoided them, I did buy them indirectly, at a discount, through Berkshire Hathaway, which was trading for far less than the sum of its parts, in 2000.

One group of deep value investments did particularly well in the first decade. Specifically stocks in the industrial materials and energy areas that benefited from the double whammy of a favorable shift in global secular trends, plus the expansion of initially low valuations. The Graham and Dodd book raised the question of whether the early twenty-first century would "favor the affluent nations through the greater production of services rather than goods, or whether this would go on the back burner to allow more of the world's people to [pursue] a greater production of goods." With the benefit of hindsight, we know that it was the latter, which led to the rise of countries like the BRIC (Brazil, Russia, India, China) nations, while causing considerable economic angst in the United States.

Another time when "deep value" did well was in March of 2009, when the Dow plunged more than 50% off its peak, and individual stocks were 70%-90% off their peaks. Some of the companies went under, but the ones that survived and rebounded to, or close to their peaks, provided quick gains of a multiple of their lows. The fact that Value Line's rankings performed in "reverse" order for one of the few times in its history in 2009, reflects this trend.

More to the point, 2010 earnings had finally caught up to the earlier "2010" stock prices (which collectively went sideways for a decade). By the beginning of the current decade, growth could be had at a reasonable price, not at "any" price, as was the case in 2000. Under such circumstances, one wants good quality stocks that can benefit from corporate growth, as well as value.

The most robust strategy at this time appears to be a blend of value and growth, buying relatively cheap growth stocks. Corporate profits and profit margins have been making all-time highs. Not every company is prospering from these secular trends, but the ones that are, are doing so in a big way.

One way to select stocks is to run the value screens run by Value Line for low price-earnings and low price to book, or high dividend yield, etc. Then choose only those stocks that are ranked high (1 or 2) by the service on earnings fundamentals. Alternatively, start with their list of highly ranked stocks, and chose cheap stocks with a P/E ratio below the market multiple (almost 20), or below some other target multiple of your choice.

Compared with the past decade, there are an unusually large number of companies that meet both sets of criteria. In a recent week, 36% of the highest-ranked (1) stocks had P/E ratios below the market multiple. That's less than the hypothetical 50-50, but still a sizeable number. Of the lowest P/E stocks, about one-third had (growth-oriented) ratings of 1 (Highest) or 2 (Above Average), versus less than one-quarter for the whole "universe."

The problem with deep value strategy that it often sacrifices fundamental strength for stock cheapness. That is a robust strategy in times like 2000, when stocks with good fundamentals are too expensive, or 2008, when there are few companies with good fundamentals to be had. But at a time like this, when there are relatively many stocks with a combination of value AND growth, it does not make sense to sacrifice growth for value. Some of my favorite (unnamed) deep value investors are doing this, and thereby underperforming a broad-based market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.