A Deep Dive Into Value – and a Warning

A deep dive into value – and a warning... The Economist's new 'buy' signal on value investing... Growth vs. Value – what does it really mean?... A steep bear market is coming... You'll be glad you've heeded the warnings...

'Does value investing still work?'

The Economist magazine posed that question in a headline for its November 14 edition.

It isn't the first time we've seen a question like that, of course...

Many such headlines have appeared over the past few years. I (Dan Ferris) included four similar examples in my presentation at last month's virtual Stansberry Conference and Alliance Meeting...

But none of those headlines came from The Economist... When a headline like this appears in The Economist, history has proven that it means more than when it appears elsewhere.

The Economist – especially its cover – is a well-known contrarian indicator...

The most famous example happened in March 1999. The Economist ran the cover headline, "Drowning in oil"... and then watched a massive bull market in oil and other commodities play out. Oil prices surged through early 2008. In reality, March 1999 marked the second great oil-buying opportunity of my lifetime (the first being the Arab Oil Embargo of 1973).

And then, a little more than four years later, The Economist reversed course with its October 2003 headline, "The end of the Oil Age." Well, 17 years later, we're still waiting.

This phenomenon is apparently so undeniable that The Economist published an article in October 2016 about its own value as a contrarian indicator. The article was based on research by two Citigroup analysts, who examined 44 covers of The Economist from 1998 to 2016...

The analysts looked at returns 180 days and 360 days after publication. After 180 days, The Economist covers were a contrarian indicator 53% of the time – roughly a 50-50 toss-up. But after 360 days, the odds were better... A contrarian bet paid off 68% of the time.

A year later, buying after bearish covers of The Economist generated an average return of 18%... while selling short the bullish covers generated an average return of 7.5%.

Perhaps you think 44 data points is insignificant. Maybe so, but the basic concept still seems sound... If an idea is popular enough to sell magazines – that's what the cover is for, after all – then it makes sense that it's likely reaching its peak popularity and will soon reverse.

I doubt value investing will ever be a big enough topic to make the cover of The Economist, though... So appearing as one of the magazine's prominent articles is about as close as we value gurus can expect to come to a full-blown "Cover of The Economist" contrarian indicator.

As editor of Stansberry Research's Extreme Value service, I'm definitely going to talk my own book in today's Digest... at least somewhat. And I'll also give you a warning. But first, I need to examine this idea that value investing has done so poorly over the past decade...

It's not what it appears at first glance...

I believe this belief is based on two separate and not necessarily related ideas.

The first is simply that the growth index exchange-traded funds ("ETFs") have significantly outperformed the value index ETFs since the bottom of the financial crisis in March 2009 – and especially over the past four years. You can see what I mean in the following chart...

The outperformance is dramatic... Over this span of more than 11 years, it has been a roughly 590% return for the growth ETFs versus around 225% for the value ETFs.

But in the roughly five-year stretch just before that – from the bottom of the dot-com crash in late 2002 to the top of the housing bubble in late 2007 – value outperformed growth. The value index ETFs more than doubled, while the growth index ETFs only returned about 80%...

As long as you define value investing by the simple metrics used to build the indexes that these ETFs follow, your argument that growth has outperformed value is solid. As we'll see in a moment, though, that might not be the best way to think about growth or value.

The second reason it's popular to talk about the decline of value investing nowadays is the recent underperformance of prominent hedge funds run by famous value investors... Seth Klarman, David Einhorn, and Bill Ackman have all underperformed and/or experienced losses within the past five years.

However, I would suggest that the overwhelming trend toward so-called "passive" investments over the past decade is at least as big of a problem for the hedge funds...

Investors have soured on fundamentals-based active investment management as the big market indexes keep climbing to new heights (and have done so without charging big management fees). It seems easier to just put your money in an index fund and forget it.

Overall, when wondering why value investing is doing so poorly, it appears that we're really talking about something else... You can no longer just throw darts at the cheapest stocks (using basic metrics like price-to-book value and price-to-earnings ratio) and make more money than if you'd bought the entire market or the faster-growing, more expensive stocks.

Those simple metrics were once a brand-new way of thinking – a way to excel as a value investor...

Investing legend Ben Graham – the "Father of Value Investing" and Berkshire Hathaway CEO Warren Buffett's mentor – pioneered this way of thinking nearly 100 years ago.

Graham used metrics like price-to-book value, price-to-earnings ratio, and dividend yield to determine if stocks were cheap or expensive.

At its core, value investing revolves around the relationship between price and value. When you pay less than an asset's current "intrinsic value" – the value of its likely future cash flows – that's value investing. In the last chapter of his other great classic work, The Intelligent Investor, Graham summed it up this way...

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, "This too shall pass." Confronted with a like challenge to distill the secret of sound investment into three words we venture the motto, MARGIN OF SAFETY.

You get a "margin of safety" whenever you can pay a substantial amount less for an asset than its intrinsic value. That's the heart of value investing... It's far less about what metrics you use and much more about how you determine the asset's value.

For example, Graham might have thought any stock was too expensive if it traded for more than 15 times earnings. But if an asset's cash flows grow 100 times in the next 10 years, 50 times this year's cash flows is a bargain. That's true, even though 50 times sounds crazy expensive to someone like Graham.

That simple hypothetical example and the recent overall poor performance of traditional value metrics both demonstrate why I believe measuring intrinsic value is more complex than any single metric or model. It's a subjective idea... more art than science.

If I were challenged to sum up the essence of value investing...

I couldn't get it down to three words like Graham.

I'd probably say something like, "Future returns are determined by present price and present value, and value is determined by a lot more than numbers."

Meanwhile, famous investor Jeremy Grantham inadvertently summed up a pure value-based approach during a recent interview on CNBC...

The one reality you can never change is that a higher-priced asset will always produce a lower return than a lower-priced asset.

You can't have your cake and eat it. You can enjoy it now, or you can enjoy it steadily in the distant future, but not both.

And the price we will pay for having this market go higher and higher is a lower and lower 10-year return from the peak.

When you buy a stock or a bond, you're buying a future stream of cash flows. You might think you're betting on the company's future revenue growth – and yes, that comes into play – but in the end, all your analysis is about one thing... You must figure out if you're likely to make a good return paying what the market is asking for the stock or bond.

Any way you define value investing and no matter how you determine that value, the whole idea boils down to the relationship between price and value. And as Grantham pointed out in his interview, that relationship determines your return... so you better understand it.

I think Graham and Grantham are spot on, even if the simple metrics that Graham used and which Grantham's comments imply aren't enough to define an effective investment strategy.

If I had to chime in, I'd say something that sounds a lot like both legendary investors, but with a twist... I'd say your return is determined by the price you pay relative to the value you're buying, and that value depends on qualitative factors as well as quantitative ones.

On the Stansberry Investor Hour podcast, I've begun featuring a quote of the week...

I plan to find these quotes throughout my own reading and podcast listening.

Last week, I shared the first quote of the week – from my old friend Chris Mayer of Woodlock House Family Capital. In a recent blog post, Mayer wrote...

As I get older (and, I hope, wiser) as an investor, I find myself giving much greater weight to fuzzier concepts such as culture and governance and competitive positioning. The numbers ultimately have to make sense, but these qualitative factors underpin my investment decisions in a way they didn't when I was younger. Experience (i.e., being burned when these factors were absent) have taught me to pay attention.

I've had the same revelation...

The financial numbers are history. They were the result of human actions that might not have been entirely motivated by the desire to generate good-looking financials. There's more to investing than looking at a bunch of numbers on a page.

So when my colleague Mike Barrett and I make new equity recommendations in Extreme Value, we look for high-quality streams of cash flow... meaning businesses that gushed cash flow in the past, are gushing cash flow right now, and which we expect will still be gushing cash flow several years in the future. Our proprietary model then tells us if the price is cheap, expensive, or somewhere in between.

The "high quality" part is subjective... And it might depend on something like corporate culture, the management team's track record, or other factors that don't show up in simple growth and value screens.

Here's part of the problem with believing value investing doesn't work anymore... People don't realize that the likely future growth trajectory of a business is part of any reasonable value calculation.

It's only when you decide to split the market indexes into cheapest versus fastest-growing or most expensive that any type of dichotomy between the two emerges.

My friend Aaron Edelheit is another investor with an updated approach to value...

Aaron is an author and entrepreneur who currently serves as CEO of private investment firm Mindset Capital. And on the other end of the spectrum from The Economist's headline, Aaron recently gave a presentation he calls, "Value Investing is Alive and Well."

Aaron's presentation contains valuable common sense insights about value investing... He reasons that the traditional value metrics Graham used underperform today due to computerized algorithmic trading and the rise of the digital economy. But in the end, Aaron concludes that "the soul of value investing still works."

Today, Aaron recommends looking for value among technology stocks, searching in areas of the market with less competition (like in small caps and international stocks), and hunting for companies that don't screen well but where "deep dive research" tells a different story.

For example, Aaron points out that Apple (AAPL) and Microsoft (MSFT) were both value stocks at one time. (By the way, we recommended both stocks in Extreme Value when they were dirt cheap.) In Episode 161 of the Stansberry Investor Hour podcast back in early July, Aaron gave an impassioned "deep dive" analysis of Twitter (TWTR)... The stock is up roughly 45% since then.

Another friend of mine, author Vitaliy Katsenelson, is a value investor, too... He discussed his approach on Episode 167 of the Stansberry Investor Hour podcast in mid-August.

Vitaliy stays away from highly cyclical companies like mining stocks and other commodity-based businesses. Lately, he has been loading up on defense stocks... They're priced right, and Vitaliy thinks the world will increasingly rely on their products and services as the U.S. and other countries (especially China) come into conflict.

We've interviewed other value investors on the podcast this year, too. And they've all given their own spin on the relationship between price and value – and how they go about finding it...

For example, in Episode 143 back in February, we talked with investor Dan Schum. He got so good at finding value in tiny, off-the-radar stocks that he quit his software job to become a full-time stock investor.

In Episode 178 three weeks ago, we interviewed my friend and deep value investor Tobias Carlisle. He has done a ton of research on value metrics – and even came up with one of his own... He wrote a whole book about it called, The Acquirer's Multiple.

Tobias once showed me how traditional value metrics performed very well in Japan during its two-decade bear market from 1990 to 2011. That leads me to believe the same basic approach can perform well if we ever get a long, difficult period here in the U.S.

And it seems like a great time to consider value stocks... Citing data from the past 200 years, Tobias says value has never been cheaper and more attractive than it is today.

Just because traditional value metrics haven't worked well for two decades doesn't mean they never will again.

As the two charts I showed you earlier imply, value beats growth for a while... then growth beats value... then vice versa... It's the ticktock of history. Cycles happen, and the cycle right now has reached an extreme it has never seen before (as Tobias' numbers show).

Now, here's the warning I mentioned in the headline of this Digest...

While traditional value is cheaper than ever and more attractive today, I expect we'll see a steep bear market before it starts beating growth again. And unfortunately, such a steep bear market is more likely today than it has ever been in history.

Let me repeat that...

Downside risk in the stock market today is greater than it has ever been in history.

How can I make such a bold statement?

Because the metrics that best measure the relationship between the price you pay to buy U.S. equities and the value you get for them are higher than at any previous time. That includes the 2000 market peak, which is now only the second-most overvalued moment in stock market history.

I only care about the value of the overall stock market when it's at an extreme level like it is today... And as regular Digest readers know, economist and money manager John Hussman's work in this arena is the gold standard for understanding those extremes.

He uses five value metrics in the S&P 500 Index, including the price-to-sales ratio. All five metrics have never been higher than they are today – including the 2000 market top. For example, the current price-to-sales ratio is around 2.6. It was below 2.4 at the 2000 peak.

Of course, valuation is a terrible short-term timing mechanism... A strong updraft is more likely to continue in the short run than anything else. As my friend Enrique Abeyta from our corporate affiliate Empire Financial Research recently pointed out on Twitter...

With the US #StockMarket indices now solidly positive for the year, expect seasonality to support a move higher. In a year like 2020 wouldn't be surprised to see them up another +5% to +10% from HERE...

I'd add that nothing would surprise me at this point... 10% higher... 10% lower... or anywhere in between.

It has been a crazy year. The S&P 500 is roughly 60% above its March bottom. It's more expensive than ever... and that perversely attracts more money in the short term, not less.

So Enrique is probably right.

But if you've been reading my Digest missives for long, you know I don't call tops or bottoms...

Instead, I say, "Prepare. Don't predict."

Fortunately, a value discipline – refusing to overpay for an asset's likely future cash flows – naturally prepares you to take advantage of a big correction to an overvalued market. You'll simply find less to buy and more to sell, which will leave you with relatively more cash when bargains abound.

I'm gobsmacked that Mike and I have found as many attractively priced, high-quality stocks as we have this year in our Extreme Value service. (We've recommended six companies, not including macro bets like bitcoin, gold, and silver... or our short sale recommendations.)

Though relatively meaningless in the short term, valuation is the force of gravity over the long term – for the exact reasons cited by Grantham... You can either pay a whole lot for those cash flows today, or you can enjoy the returns from them in the more distant future.

But you can't do both.

Today, investors buying U.S. equities are paying more for those cash flows than ever...

Hussman's estimates suggest that a portfolio allocation of 60% in the S&P 500, 30% in long-term U.S. Treasurys, and 10% in short-term U.S. Treasurys would cost about 1.56% per year over the next 12 years. In other words, starting today, his estimated annual return on that portfolio is a negative 1.56% for 12 years. That's a lot of money to just throw away.

Grantham's asset-management firm, GMO, also makes return estimates... And GMO's latest seven-year forecast calls for negative returns in U.S. large cap, U.S. small cap, large cap international stocks, and all bond types except emerging market bonds... where it's predicting tiny annual returns of just 0.3% per year from the current prices.

It's a dire picture. And yes, I've painted it multiple times over the past three years...

Sometimes, I sounded the alarm right before a big drawdown – like in the fall of 2018. But overall, the market has continued roaring to new heights and has yet to enter an extended bear episode like what we experienced from 2000 to 2002 or from 2007 to 2009.

Simply put, so far, I've been wrong to be so bearish and you've been right to buy every dip...

However, I still believe the next big bear market will be worse than those two – or any other in history. It will be on par with what investors experienced during the Great Depression from 1929 to 1932, when the Dow Jones Industrial Average lost 80% of its value.

That wouldn't be a startling outcome... since the current market is more overvalued than any other, including the 1929 market.

Maybe my timing won't be so great once again. Maybe I'll still be wrong for another year.

But like I told you last week, I feel like I'm falling down on the job if I don't issue warnings for all of my readers upon seeing such extreme levels of risk in the stock market.

Because eventually, the tide will turn. It might not be today, tomorrow, or even next year. But at some point, the bubble will pop... and everything will come crashing down.

When that happens, you'll be glad you've heeded my warnings. You'll be glad that you've allocated some of your overall wealth to cash, precious metals, and bitcoin. And best of all, you'll be glad that you can once again find value opportunities everywhere you look.

New 52-week highs (as of 11/19/20): Morgan Stanley China A Share Fund (CAF), Cresco Labs (CRLBF), New Oriental Education & Technology (EDU), Futu Holdings (FUTU), GrowGeneration (GRWG), W.W. Grainger (GWW), Jushi (JUSHF), Silvergate Capital (SI), T-Mobile (TMUS), Verisk Analytics (VRSK), Vestas Wind Systems (VWDRY), Zebra Technologies (ZBRA), and Zendesk (ZEN).

In today's mailbag, feedback on yesterday's Digest about the United States of Amazon. Do you have a comment or question? Send your notes to feedback@stansberryresearch.com.

"Corey McLaughlin's article regarding the ever pervasive Amazon was very informative and made a good case for investing in Amazon as a business.

"The other side of the coin is that my immediate reaction was a flashback to the Zik-Zak Corporation that controlled the world in the series Max Headroom.

"My libertarian instincts tell me that Amazon has the right to be the best company it can be to the benefit of its shareholders but those same instincts scream that too much control is accumulated by one entity.

"Makes me go Hmmmmm." – Paid-up subscriber Paul H.

Good investing,

Dan Ferris
Vancouver, Washington
November 20, 2020

P.S. As I said earlier, even though growth has outperformed value in recent years, Mike and I continue to find attractively priced, high-quality stocks in Extreme Value. And our subscribers are reaping the rewards... The six companies in our current portfolio that we've recommended so far this year are up an average of 26% while we've held them.

We plan to keep uncovering gems like these for our subscribers as often as we can... In fact, in our November issue last Friday, we just recommended a COVID-19-resistant business. This small-cap stock operates in an industry that all politicians love... It has an excellent long-term growth outlook... And best of all, it comes with a clear margin of safety.

Right now, we're offering a special deal for all Digest readers (and your friends, too, so spread the word!)... You can get Extreme Value at 33% off the regular price. And this offer includes something else to make sure you're completely satisfied. Get started right here.