What Is A Measure Of Value?

by: Lloyd Clucas


WSJ article (6-5-18) makes clear that “value” investors are lost in space. Some act as dim as CAPE-10 acolytes have been for years.

Book Value, for example, rarely measures anything useful today. It is something from Neanderthal days. Many value-driven indices thrive on it. Now they wonder why they are getting thumped!

Today’s “Platform Economy” (a Gave-Kal concept) generally thrives on brains, not brawn; thinking, not factory space.

Share buybacks melt “Book Value”. Those of us who use “book” have to constantly adjust the “normalized ROE” appropriate for the shrunken book. It is difficult and surely imprecise.

High book value is often likely to encompass many sunk costs that will never be recouped; "stranded assets". Regulators may help them, but not consumers.

We are value investors. However, we have always combined it with relative price strength. Each is critical to us. Much more value-oriented than Bill Miller ever was. On a risk-adjusted basis, I have us beating him over his spectacular run of beating the S&P 500 (SPX) – through until he didn’t.

But he had the right idea. If you don’t have them, you lose. Bill didn't try to drive forward using the rear-view mirror. For instance, Bill understood Amazon (NASDAQ:AMZN) when we/I did not. [We still don’t own it, despite Al Gore’s recent reported selling! However, if reports are accurate, we probably bought our first two tranches of Facebook (NASDAQ:FB) from Al in February.] Up well, so far.

As I recall, Bill’s career actually ran afoul of betting too early on recoveries in housing (and financials?). Glug, glug… glug! Sorry Bill, we’ve always managed to skip that last part. Overconfidence can affect us all! It swallowed him.

The WSJ: “Value stocks — traditionally shares of consumer-staples companies, basic materials firms and big manufacturers, among others — have been stuck in a rut for most of the nine-year rally in U.S. stocks. The Russell index of 1,000 of the biggest value stocks in the market has fallen 2.1% in 2018, the fifth straight year — and the 10th of the past 11 years — that the index has lagged behind its growth counterpart, which is up 6.9%.”

Value contains just three components: (1) The ability to generate humongous amounts of free cash flow relative to share price on a more-or-less regular basis and preferably growing it at a sustainable pace. (2) A shareholder-friendly management which does not eat the shareholders’ lunch. (3) A management willing to hire the best brains available and focus them on potentially-useful projects, preferably within managements’ competence. Intel (NASDAQ:INTC)? Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL)? Microsoft (NASDAQ:MSFT)? Oracle (NYSE:ORCL)? Apple (NASDAQ:AAPL)? We own all – big. They were all undervalued when we originally bought them.

A long-term growth assumption is part of valuation. Always has been. As noted, we have also required positive relative strength in addition to good valuation – when good valuations are to be had. At today's stage in the market, centrally-valued, with good relative strength will do for an initial purchase or addition to an existing equity position. Vanguard’s emerging markets’ ETF (NYSEARCA:VWO)? FedEx (NYSE:FDX)? Magna International (NYSE:MGA)? Eastman Chemical (NYSE:EMN)? We own all of these big, too. So far, so good.

The numbers will, eventually, show you who is doing it right and who isn’t. You usually have to wait a while. Forecasting it in advance is dicey at best; devastating at worst. Buffett often does it well; sometimes Miller did it well, we often do not. Fortunately, we know that in advance. We win because of it.

I don’t want to sound like a loser in a Clint Eastwood movie (Magnum Force), but “a man has got to know his limitations”. Knowing what you don’t know, and knowing what you will never know with functional certainty, is as important as what you do know. [And, Yes, I recall the apt Mark Twain quote. It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.]

Which brings us to what is happening in today’s booming equity market. We think we “get it”. The market started to go parabolic in January. Then it sold off and went through a routine consolidation process. Now it looks to be breaking upside – as we suggested it would some weeks ago. Yes, the market is overvalued. We expect it to become seriously more so.

The rationales for our staying in stocks at current overvalued levels can include:

  1. understanding late-stage market momentum; and the narrowing of markets into big caps which that tends to produce;
  2. realizing that a long, slow recovery tends to keep the bulls working longer ratcheting up valuations faster than underlying fundamentals while liquidity is present and liquidity preferences are shifting toward equities;
  3. expectations that the global and US economies and earnings will improve – even a very modest amount;
  4. the desire to keep dividend income growth going up; cash returns hadn’t even gone up to equity dividend returns; well, until almost now!
  5. wanting a value-added process working for you; no straight debt issues ever do that;
  6. fearing that our massive “monetary inflation could easily be turned into serious price inflation;
  7. seeing a lack of decent, competitive alternatives; and
  8. realizing that global governments really have made things different this time; Trump “hope” is fading and “fears” rising; but tax cuts and regulatory relaxation are already here and are, generally, serious positives. And, while the ECB is implying it will stop soon, the ECB and BoJ still pump out “money”.

Our current long case is based on psychology and economic conditions.

Others may not agree. Quite understandable and OK for those whose comfort zone would be violated outside their familiar sandboxes. We are definitely UNCOMFORTABLE – right now! Here are some more reasons we are willing to endure that.

WSJ: Eddie Perkin, chief equity investment officer at Eaton Vance: “‘The FANG stocks are so dominant in those benchmarks that to not own them, you got really hurt the last few years,’ he said. So you had to have those in your portfolio to keep up with other growth managers.’”

This fear of missing out or lagging their “competition”, “style”, or “benchmarks” drives a lot of otherwise intelligent managers to do silly things. We think that will continue, but that we will not do such. Yeah, pride goeth….

Other value managers are blurring what they call value. We are not. We are just giving more bias to relative price strength. That is what usually dominates at the end of long bull markets. So far, just this year, the loony tunes Russell 2000 (RUT) has led the breakout to new highs, closely followed by the NASDAQ (COMP). As to the RUT, please see the Declining Number of Traded U.S. Equities Impacts Small-Caps article in T. Rowe Price’s Fall 2017 Report. It features much lower quality, plus lack of earnings for ~ 1/3 of the RUT. It ain't your dad's RUT.

Jared Dillian has a good piece out today (6-7-18) about the number of price-insensitive buyers there are in the markets vs. 20 years ago and how that is creating just the sort of market we are in today. He doesn’t discuss the prevalence of algorithmic trading. I do not know its net effect on market sanity. My weak guess is that it is not helpful.

We simply believe we know what stage this market is in – as well as what and who is running it. It is approaching a bubble and a blow-off. Do we think such will occur? Yes! Especially since the minor leaguers have been screaming about bubbles for so many years now and been proven so wrong. Fewer and fewer will come to listen to them. Eroding Wall of Worry. Higher prices – for a while. Nevertheless…

We are at 29-32% cash in our portfolios right now. No bonds, of course. All else are equities, foreign and domestic, emerging and developed. That cash is a buffer for the elevated risks we see in this market. Our best guess is that Valuation Risk and Trade War potential are the two biggest risks. There are no signs of Recession Risk starting this year or probably even early next. That “all-clear” is a big deal – to us. The only caution is in the deterioration in some of the leading indicators we follow. But none are yet close to signaling a recession coming soon. Not even close. To us, that is critical. Others may see it differently. As the risks rise, we will raise our cash percentages. Note: Some 20+ years ago I asked the legendary value investor John Neff, face-to-face, how large a Cash percentage a professional should permit in client portfolios. His answer: 25%, as I recall. So we are at high cash now? I'll go higher.

For the record, as of 6-8-18, we have the DJIA 40% overvalued. Our portfolios have been out-performing and are hence now ~ 28% overvalued! Appalling! But we haven’t updated through 1Q18 statistics yet on valuation. It is probably less for our portfolios, but we won’t know until we do the work in a few weeks.

I wish public bears (and bulls) would report their actual personal asset allocations. Not the specific assets, just their own asset classes and percentages. We do that for clients each quarter. We eat our own cooking. They know it. We rarely know any of that about the hysterical bears – or bulls, either.

Related point: It would be also interesting to know what those bears’ personal income stream sources are. Percentages, not actual amounts. I know mine, but confess I don’t make a habit of disclosing it, either. Long-term capital gains have dominated for 9 of the last 15 years. But on our future guesswork, that won’t likely last long!

We lead the major big-cap indices so far, this year, even with our cash. Will we get out or, more likely, raise “enough” cash before the market breaks big-time? I do not know. We will try. But I will not worry about it if we do not. I suggest you shouldn’t, either. But dry powder and extra ammo are suggested. We find it much easier to identify market lows than market highs. There are no limits to upside insanity. Maybe you believe differently.

Investors need to get over their asymmetric fear of “loss” over prospective gain. They need to stop thinking that their recent portfolio price highs mean anything. Don’t “anchor” to spacey quotes. That is why having a reasonable, though highly imprecise, estimate of central value for everything you own is so important. And I don’t mean via the CAPE-10!

That idiots think your companies are great at nutso prices just doesn’t matter! It is still the same company doing the same things. The central value for a good firm is likely to rise modestly each year, whether earnings and prices do, or not. With no recession in sight, good investors may want to “help” the maniacs by giving them a little more of their stock as prices soar. Best not to go all-or-nothing at high levels. Neither you nor I will know the high in advance. Neither will the maniacs. But it is fun and profitable to feed those maniacs.

Materially undervalued lows are another matter. But we won’t be seeing those soon! So we’ll not discuss them here.

Professional investors: “Styles”, “Benchmarks”, Competitive risk, Marketing, and Consultants are all serious barriers to serving clients well. [See Jeremy Grantham’s excellent quarterly pieces on that years ago.]

All these impediments push managers to become plates of vegetables. And they are marketed as such. Don’t stray too far from the herd or slide off the plate, either! Managers who go along, get marketing help. Those who don’t, run serious business risks for themselves, but may serve their clients better. I recently heard a prissy doctor say he was “uncomfortable” doing what a patient wanted – not illegal – just “uncomfortable”. What a wuss! In our profession, if that is what it is, we are NOT paid to be comfortable. Quite the contrary! We are paid to be uncomfortable – for investment success. That is part of value investing. COMFORTABLE is when we are being paid to hold clients’ hands. That is managing your own business, not client portfolios.

Our profession needs to emphasize that. It doesn’t. CFA Institute, please copy. (I’m happily a CFA and Institute member. But that is another subject for another day.)

Individual investors, for all their handicaps, should not let themselves be burdened with what hobbles the pros. If able to exercise real independence, individuals can be free of those constraints. However, if they insist on buying mutual funds or ETFs managed by others, they must spend some serious time learning about the implied “agency risk”. It is substantial! And a subject for a different article.

As Hill Street Blues’ Sgt Esterhaus used to close his briefings: “Hey, let’s be careful out there.”

Disclosure: I am/we are long ALL THE FIRMS MENTIONED.

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.

Additional disclosure: None of the article is intended as investment advice to anyone. It is just a reflection of my outlook and hope it may prompt others to do the sort of work we do. Their conclusions from their own work may differ.