Value investors focused on buying assets at a discount are having a tough time, given the huge Value underperformance to Growth or Momentum stocks.
Recent performance, as well as structural issues, have called into question the durability of Value's historical outperformance in the long term. But there may be hope for troubled value investors.
Elegant Hotels Group Plc, a UK microcap which owns hotels in Barbados, may offer an interesting case in point.
These are no doubt tough times for traditional value investors, i.e., those who focus on companies with low multiples that the quantitative Value factor measures. Value vs. Growth charts and data points show the huge underperformance of the former in recent years, and the currently record valuation premium of Growth vs. Value in historical terms —only comparable with the late 90's of the dotcom bubble.
Source: Norbert Keimling.
Donald Smith & Co is just one example of that type of value investor that I’d like to highlight. It has an excellent track-record of almost four decades investing. With the data I have, it has beaten the market by almost 4 percentage points in a period of 26 years, obtaining an annualized return of 13.6%. It is a “deep-value” investment firm, focusing on companies in the lowest decile of stocks according to the price-to-tangible book value ratio, although it is obviously not the only metric they look at. An investment style that is currently denigrated and that many think is no longer valid, given the emergence of high-growth technological business models with high returns on capital, low capex needs and strong intangible assets.
The most recent performance —value underperforming— seems to confirm this. As Donald Smith's co-CIO, Richard Greenberg, acknowledged during a recent visit to Madrid, this has been a tough time for them in particular, and for value investing in general. According to data shown by Mr. Greenberg, the spread in the performance of the cheapest stock quintile according to the P/E ratio versus the performance of the most expensive stock quintile, has favoured the most expensive stocks both in 2018 and 2019 at a level not seen since 1999. In that year, the most expensive companies returned 70 points more than the cheapest stocks! In 2018 this spread was 22 points and 15 points in 2019 up to August. In other words, it is true that "expensive stocks are becoming more expensive, and cheap stocks are becoming cheaper". Using somewhat different metrics to those of Greenberg, we can get a partial glimpse of this idea in the following chart, which shows 2018 performance broken down by quintiles according to the next 12 months P/E:
Source: Broyhill's 2018 Annual Letter.
This underperformance of the so-called cheap stocks was particularly brutal in August this year, as the S&P 500 fell just 1.8% but the stocks in the lowest P/E decile plummeted by 11.5%:
Source: Nir Kaissar.
In this context, it’s worth to remind ourselves that, historically, investing in the cheapest stocks has offered market-beating returns:
Source: Donald Smith & Co.
However, aren't critics of investing in low-multiple stocks are right in believing that we have entered a different paradigm and historical performance data (reflected in the chart above) are no longer relevant?
As an indirect way to answer the question, today I wanted to provide a real and current example that offers some hope to investors focused on acquiring assets at a discount. It is that of the UK-listed microcap Elegant Hotels Group, which a couple weeks ago skyrocketed 57% after the announcement that the company had reached an agreement to a cash offer from Marriott International, which would value it at £100M ($130M). That 57% rise was the premium Marriott offered relative to the price it traded before the news.
This is indeed a tiny company, but I think it highlights interesting things. Elegant Hotels is the owner and operator of seven upscale freehold hotels and a beachfront restaurant on the island of Barbados. I personally knew about the company because it was held in the portfolios of two mutual funds I follow in Spain (Magallanes Microcaps Europe and CIMA Global Value). I actually found the news from a portfolio manager of CIMA Global Value, who wrote the following short remark: “When assets trade at a 50% discount…” That prompted me to think and write this article.
These corporate deals are a way in which the value that the stock market is not seeing about a company and its assets can just emerge overnight. But sometimes the investor may get a bittersweet feeling. “Bitter", because what the buyer offers may be less than what the "intrinsic value" estimated by the value investor suggested, as has happened recently in the European market with a few industrial companies. But, even if the above has occurred, it is also a "sweet" feeling because the wait may have been very long and frustrating, seeing day by day how the company is valued by the market at a very large —and even increasing— discount on the value of the assets, for a long time. And the takeover bid is a demonstration to the investor that he was right in his assessment that the market undervalued the company.
In such small companies, inefficiencies of this type are more common and large, but it can also take a long time before this inefficiency is resolved, either through a gradual "organic" rise in the share price —for some reason it begins to appear on the radar of more investors or the undervaluation goes to extremes— or through this type of corporate overnight deals. But it's not uncommon that in these investments, as a Spanish value investor usually says, you look like a fool for most of the time and one day, all of a sudden, the market agrees with you and the stock price soars. Sometimes with a catalyst, sometimes without one. There are many investors who only invest when they see clear catalysts. That can sometimes work, but it won't in cases like Elegant Hotels where we've seen that in the absence of clear catalysts and with the price at a low, it's simply a takeover offer that brings out the hidden value.
So, perhaps the conclusion is one of hope for the troubled value investors, like Donald Smith & Co or many others, who see that their companies should be worth much more according to their estimates —I know a few value managers who find their own portfolios as undervalued and attractive as ever—, but the market does not pay attention. But ultimately, patience pays off… provided, of course, that the analysis is right. Elegant Hotels may have just taught us that lesson, again.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.