Buying Value In A Good Ol' Bull Market

by: Smead Capital Management

The last ten years included the worst bear market in 80 years.

Whether you are in the “doomsday” camp, the “watch the interest rate” camp or the long-duration camp with us, the challenge is to find value investments.

Over ten years, we expect historical academic evidence to be reconfirmed and will continue to practice long-duration common stock ownership seeking the statistical edges which have worked in the past.

Many well-regarded experts have weighed in on the length and the pricing of common stocks eight and one half years into this bull market. They range from the dire warnings of perma-bears like Marc Faber to more reserved warnings from Howard Marks and Robert Shiller. The chart below shows an example of where we are in relation to history:1

Machine generated alternative text:S&P 500 Valuation Versus GDP A Buffett Indicator Variant: Wilshire to G D p The GDP SMEAD

Separately, Warren Buffett and Jeremy Grantham have argued that the expensiveness of this market must be weighed against the prevailing interest rates. As recently as May of 2017, Buffett said, “If I knew that the ten-year Treasury Bonds would remain near 2%, there were two companies I should have purchased last year.” In theory, the lower the riskless rate the more the future income stream of a company is worth. Grantham has effectively argued that the low interest rates make it “different this time.” The last time that we checked, those are the scariest words in investing.

Therefore, whether you are in the “doomsday” camp, the “watch the interest rate” camp or the long-duration camp with us, the challenge is to find value investments. These value investments must be consistent with how you found value in the past. What does academia tell us about how to find alpha (outperformance) from a historical standpoint? Does this provide a template for how to make money against the current backdrop?

Valuation Matters Dearly

Eugene Fama and Kenneth French exposed the fact that inexpensive stocks outperform average and expensive stocks based on book value. David Dreman, in his book “Contrarian Investment Strategies,” used price-to-earnings (P/E) ratios to prove the same point. Both results were based on annual re-balancing of the S&P 500 Index companies via five price quintiles. Their results are shown in the following charts.2,3

Machine generated alternative text:Fama / French: Valuation Effects in the US Annually 1927-2012 Annual Return Ann Standard Deviation 11.64 Large Value 26.87 9.82 500 20.30 9.25 Large G r owth 20.33 14.77 Small Value 31.55 11.54 Small Ma rket 30.66 8_69 Small 33.06

Machine generated alternative text:Dreman: Correlation of Returns by P/E Quintile 153 10B Low lag 92 2 11.0 3 4 High 11.7 Market Annual Returns by P/E Quintile Price/Earnings January 1 , 1970 December 31, 2010 Total Retum Dividend swrce: a David 2010. Data source: Data

We love the oldest of these studies from Francis Nicholson, who showed that bargain prices can lead to more alpha when attached to longer holding periods. We believe bargain stocks are the gift which keeps on giving:4

Machine generated alternative text:Francis Nicholson

Concentrated Portfolios and Long Holding Periods

Whether you are in bull or bear markets, the academic work shows that alpha can be produced by high conviction portfolios which practice low turnover. Martin Cremers and Ankur Pareek have proven this and given us a chart to help us understand:5

Machine generated alternative text:1. The Benefits of a Long-Term Active Approach Excess returns ot U.S. equity mutual funds by holding period and active share, 1995-2013 1.9% U.S. EQUITY Longer holdng period. higher active share Shorter holdng period, higl-er active share -1% Longer holding period, lower active share Shorter holdng period, lower active share 0% 1% -0.9% -1.2% 2% Source: Martijn Cremers and Arkur Pareek. 2014. "Patient Capital Cutperformance: The Investnent Skill Of High Active Share Managers Who Trade Infrequently." Working paper, Annu*ized returns relative to the fund

Concentration (high active share) and low turnover may improve performance on average. Warren Buffett always reminds us that “excitement and expense are the enemies of your portfolio.” Turnover definitely causes expense.

Quality Adds Value

Ben Inker, via his impressive research at Grantham Mayo Van Otterloo and Co. (GMO), revealed four qualitative factors which demonstrated alpha over a 24-year time period.6

Machine generated alternative text:Leverage High Quality Lo Profit Margin Hi 1.0% -2.0% Earnings Volatility Lo 1.7% -2.0% Hi Lo 0.5% Stocks 500 Riskier 1.0% -1.0% Hi -2.6% Hi

Can you see the template which the academic studies and history have provided us? We seek to combine bargain purchases made in psychologically difficult circumstances of companies which fit Inker’s quality characteristics and hold them longer than our competitors.

What Industries Dominate the Lowest P/E Quintile?

As of September 25, 2017, the 100 cheapest stocks in the S&P 500 Index were concentrated in 31 financial stocks and 30 consumer discretionary stocks. Older technology stocks were the next most concentrated in the index with 10, followed by 6 industrial stocks. Therefore, if the lowest P/E quintile is going to outperform the S&P 500 over the next five to ten years, it means that the stock market could well have gone overboard on punishing financial and discretionary companies for the negatives which exist in their sector and industry. Here is what the last ten years looked like for the lowest P/E quintile versus the S&P 500:7

Machine generated alternative text:Value of $100 Invested (Log scale) • Generic Value(P/B) S&P500 Generic Value (P/E) $250 150 100 50 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Sources: Ken French and Alpha Architect

The other possibility is that value outperforms the S&P 500 by virtue of how horribly growth stocks do and how over-weighted the index has become in high P/E stocks. This was the historical aftermath of the early 1970s “Nifty Fifty” bubble and the Dotcom bubble of the late 1990s.

Merging Value with Quality

At Smead Capital Management, we seek to merge the academic work on quality from Ben Inker/GMO, low turnover and concentration from Cremers and Pareek, with the value work of Dreman and Nicholson. We seek to initiate positions in companies which meet our eight criteria for stock selection when they fall into the lowest P/E quintile. Currently, Alaska Airlines (ALK), Target (TGT), Kroger (KR), Aflac (AFL), Wells Fargo (WFC), Lennar (LEN), JPMorgan (JPM), Bank of America (BAC) and Nordstrom (JWN) are in the lowest quintile.

In our opinion, they are not only quantifiably inexpensive, they are also qualitatively strong in relation to the lowest P/E quintile shares and the S&P 500 overall. We seek companies with long histories of profitability, wide moats, high and consistent free cash flow, strong balance sheets, heavy insider ownership with recent purchases, shareholder friendliness and buy them at price points which are depressed compared to the last five years.

Where Do We Go From Here?

The last ten years included the worst bear market in 80 years. Given the fears of a deep bear market, of mean reversion in U.S. equity performance and mean reversion of Treasury interest rates, there are no guarantees. However, there weren’t any guarantees at any stage of my 37 years in the stock market. Over ten years, we would expect historical academic evidence to be reconfirmed and we will continue to practice long-duration common stock ownership seeking the statistical edges which have worked in the past.

1Source:Advisor Perspectives (

2Source: Dimensional Fund Advisors (

3Source: Dreman Value Management (

4Source: Francis Nicholson study – shown in “Contrarian investment strategies: the next generation”, By David N. Dreman; Pg 143

5Source: ThinkAdvisor ( Data for the time period 1/1/1995 – 12/31/2013.

6Source: GMO monthly data 1/1982-12/2003.

7Source: The Wall Street Journal (

FAANG stocks include Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Alphabet (GOOGL).

The information contained in this missive represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

©2017 Smead Capital Management, Inc. All rights reserved.

This Missive and others are available at

Disclosure: I am/we are long ALK, TGT, KR, AFL, WFC, LEN, JPM, BAC, JWN.

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.