At this time, this could be considered the most important question or the least important question, depending on how you interpret it. Given the current market environment for disciplined value investors has likely only been this attractive once before, it is worth spending a little time giving this question some thought.

Our view as a firm is that value investing is investing. We believe that making an investment involves paying a price for an asset where the discounted value of the cash flows you will receive from that asset is assumed to be higher than the amount paid for the asset. Everything else is speculation. This should seem obvious and a given, but we would argue that the vast majority of “investing” today does not adhere to this principle. A large contributor to the present disconnect in price versus value relates to the efficient market theory, and the market’s belief that the current price is the right price. It also relates to market distortions created by passive index flows. We plan to release a separate note focusing on passive investing and its impact on the market. We will highlight the underlying flaw in arguing for passive investing’s seemingly inevitable path to market dominance. The estimated 43% of equity assets in the US market invested passively use the algorithm described succinctly by Michael Green of Logica Funds as “money in = buy, money out = sell.”

That algorithm approximates to a long-term momentum strategy, which has a clear impact on the lack of value-based priced discovery in the market. We also believe that a majority of assets in the quantitative space (which has a higher impact on trading volume) either do not implicitly attempt to value securities or do so in a manner that may consider the overall “value” of the market or subsectors, but do a poor job of individual security valuation. There are numerous other strategies such as momentum, quality, and a diaspora of other types that also eschew traditional valuation work and can only be loosely called investing. At a fundamental level, we believe that all “investing” must consider the price paid relative to the value received. Unfortunately, over the last few years there has been a blatant trend away from this basic truth.

What Value Investing Means to Us

We believe that value investing, or simply investing, is about buying a business at a significant discount to its intrinsic value. It does not necessarily mean value investing as in the traditional value versus growth framework or in the pure factor approach as finding businesses cheap on a metric relative to a universe. Having said that, however, our investment process at TSW is not agnostic about value investing in a philosophical or strategic sense. We believe that the richest vein to mine for companies trading at a significant discount is where businesses are trading at a low price-to-cash flow multiple. Due to fear, ignorance, misunderstanding, or the myriad of other reasons that cause people to have very low expectations for the future of a business, history has shown that it is easier to find mispricings in this group than to forecast growth for businesses where expectations are already elevated. We recognize that while forecasting growth can be done and there are plenty of successful growth investors out there, we prefer to play a simpler game.

Simple, however, does not mean easy. Buying businesses with low expectations means that there is a much higher chance of looking foolish, and as an investor you have to be comfortable with that. A low multiple means that most of the time people know that there may be a problem with the business and there will be many market participants constantly questioning you for not seeing those problems. There is not much emotional satisfaction in being a value investor, and it requires a high pain tolerance. It also requires a balance to have conviction that your assessment of risk and reward is sound despite the prevailing wisdom, yet also maintain the intellectual flexibility to admit when you are wrong.

Value traps are always a hazard in our type of investing and despite our quest to find catalysts and signposts to guide us after we underwrite an investment case, we will inevitably make mistakes in our assessment of some businesses. The key is to find enough situations with the positive asymmetry to allow you make such mistakes yet still generate attractive risk-adjusted returns on the whole. Having said that, we do believe that companies trading at low multiples of normalized cash flow provide a fertile hunting ground (and will cause us to correlate to some degree with quantitative factors aligned with cash flow), but it is important to recognize that there is nothing about the factor itself that makes a business attractive. A company that looks less attractive on the quantitative factor may be even more attractive once you spend time doing the fundamental work to ascertain the “normalized” cash flow.

Although we aim to not be overly reliant on an optimistic outlook for growth or to put too much emphasis on the sustainability of profitability, a significant part of our fundamental analysis is understanding the nature of the business. We try to understand what those cash flows will look like over many years and through an investment cycle. Every company should be judged on its own merit and not based solely on its price to cash flow multiple on current cash flow levels, as some more simple systematic value strategies do. Although our portfolios’ P/E ratios and other cash flow proxy metrics will typically trade at a discount to the average multiples of the relative value indices, there will also be times when we are more in-line with the indices on a valuation basis. Furthermore, in a world the opposite of today where no one believes in growth of any kind, it is not an impossibility that our valuation metrics could even be higher than our value benchmarks.

Decussis Horribilis

There is such a deluge of available charts and analysis to illustrate the difficult decade or so that value investing has endured relative to growth investing that it is difficult to decide which ones to highlight. The underperformance of value relative to growth for the last decade is either the worst ten-year performance in history or just behind the one that ended in May of 2000, depending on which valuation measure you use. Of course, we must recognize that value investing had its best ever ten-year outperformance over growth prior to this lost decade of value investing, and “value” actually looked about one standard deviation expensive relative to growth. Some outperformance by growth as a style over the last decade is, therefore, not that surprising. It is also true that for a meaningful period of the past decade the fundamentals of “growth” companies have been superior to those of “value” companies. We believe, however, that this ended in 2016. What we have seen since then is an increase in the relative multiple of the growth universe relative to the value universe such that, depending on which metric you consider, the premium of the growth universe is either at the greatest premium on record or just below that of the peak in 2000. It is also important to realize this disparity between growth and value cannot be solely attributed to business quality differences.

“Boy, that escalated quickly…I mean that really got out of hand fast” - Ron Burgundy, Anchorman

The last three years or so have introduced us to the asymptotic (and hopefully approaching the fin de siècle) part of the move. Dan Rasmussen of Verdad Capital produced the following charts showing the relative performance of the top quartile of cheap and profitable companies compared to the bottom quartile of expensive and low profitability stocks over the last decade and last sixty or so years.

Growth of $100 in Global Developed Markets (2010–2020)

Growth of $100 in global developed markets (2010-2020).png

Source: Ken French data library (June 2020).

Long-Horizon Outcomes in the United States (1963–2020)

Long-Horizon outcomes in the united states (1963-2020)

Source: Ken French data library (June 2020).

Does Value Investing Still Work?

“Does value investing still work? I have three answers, yes, no, and I don’t care.” - Joel Greenblatt

Over the recent history, the answer is clearly “no”. In the value versus growth universe, value has underperformed for more than a decade. On a factor basis, the answer has also been “no” for the last five years or so. And for us here at TSW, the answer has been “no” for more than three years. But if you are willing to extend time-horizons, value is still clearly the best style and factor performer, despite the significance of its underperformance over recent time periods. That, however, does not answer the question of whether it still works looking forward. While we live in an uncertain world, it is very clear how one should bet. History does not always repeat, but it usually rhymes. And everything we are seeing and hearing today looks very familiar. All of the reasons about why value investing has outperformed over history continue to be true today. There is nothing comprehensive in any data that we have seen to make us feel differently. Ultimately, we are not overly concerned whether value as a factor or as a style outperforms. If we do good valuation work on businesses and pay a discount to what those businesses are worth, we will be proven correct eventually. That is the magic of value investing. We do not know when this magic will come to fruition. As part of our investment process, we identify potential catalysts that will hopefully close those price-to-value gaps over a reasonable period.

If we do good valuation work, are patient, and have an adequate batting average, the returns will come. The difficult thing is the timing. Bettors at the racetrack face a negative 15-20% headwind to being profitable in their trackside endeavor – a far more challenging game than the positive expectation we feel is inherent in our investing strategy. And our strategy is deployable over a much larger potential profit pool. Granted, a horse handicapper does not have to worry about speculative bubbles affecting their returns! With around 20-30 minutes between races, and 1-2 minutes for the race itself, the resolution between price to value is realized quite quickly. With that 15-20% track take, irrational decisions are ground down to ashes over a relative few racing days and the market will stay generally efficient. There are opportunities for value investors. But there is no other type of profitable “investor” in horse racing. The fact that because there are many years to decades to find the right “value” in equities allows for fantastic deviations for companies, industries, and even the market itself between price and value. And that is the very secret of why value investing works.

But When Will It Work?

This is a question we hear more and more, and it will probably have to become deafening before we learn the answer, but maybe we are close. I remember quite well when I started at TSW in early 2001, it was not immediately obvious that the growth-value trade had peaked nine months earlier. What was obvious, however, was how extreme the valuations were between cheap and expensive stocks. Many market observers claim that value cannot work again until the economy sees reflation and higher interest rates. There is the view that zero discount rates mean you can capitalize total addressable markets in growth stocks. Many growth stocks have recently shown some correlation to this theory. We, however, do not find this a convincing argument. Interest rates are not an independent variable as they relate to economic growth and you could argue that the cash flow yield of equities would be more attractive in a world without nominal yield in investors’ fixed income portfolios. Take the example of Japan. Small-cap value strategies are the only strategies that have worked in Japan since the biggest bubble of all-time popped in that market in 1989, despite an even more prolonged period of zero rates since.

Historically, one might think that a down market would be the time for value to shine, but as shown below, the first quarter of 2020 belied that notion.

Ned Davis Research Multi-Cap Equity Universe Factor Performance | As of 9/30/2020

Ned davis research multi-cap equity universe factor performance

Source: Ned Davis Research Inc. October 2020

*Actual dates are 1/2/1981 to 12/27/2019 and 1/3/20 to 9/25/20 due to Ned Davis proprietary calculation frequencies. Bear markets are identified by Ned Davis.

It is difficult to identify the needle that will pop the current bubble. When thinking back to the end of the 2000 growth bubble, it is not even clear in retrospect what the catalyzing event was for the ensuing decade rally in value. If pushed to guess what will end the current bubble, it is worth considering what possibly led to the end of the 2000 bubble, the eventual end of the “bezzle”. This is likely a topic for another View from the Backstretch, but the current rhyming with the late ‘90s does not end with just valuation. Enron peaked in valuation in May of 2000 with a P/E of 90.75x and traded below a dollar by December of 2001. Worldcom suffered a similar fate within the year. Value had a brief shining month in September 2019. It was a glorious few weeks. Why? It’s not possible to know for sure, but the filing of the WeWork S-1 on August 14, 2019 followed by the removal of the emperor’s clothes and the reduction of around $50 billion in ethereal market value was likely more than coincidental. The market did not seem to respond recently to Wirecard, but will it eventually respond at some recognition point? In this environment, is it possible that the current bezzle could be a magnitude or two larger than we have ever seen? Is Tesla the pin? Softbank? Alibaba? There are lots of good candidates out there. Keep an ear out there for the voice of the small child saying, “But he doesn’t have anything on!”

We Think It Will Be Worth the Wait

To be perfectly frank, we do not spend much time thinking about when there will be a regime change. We would side with Joel Greenblatt in the answer that “we don’t care.” We believe we do exceptional valuation work and our clients will be rewarded with excellent risk-adjusted returns. We spend each day following our process and looking for those attractive mispricings. But “perchance to dream,” what could a regime change look like? The most comparable time period we believe is the 2000 peak. To be clear, we have no idea on the timing. We remember back to 1998-99 when we blew right past the 1929 and 1973 top and recognize there is no guarantee how far the rubber band might stretch or whether this time truly is different. Using the 2000 peak as a comparison, however, it is worth pondering the following exhibit.

Current Valuation Headwinds Parallels the Underperformance of 1998 & 1999 | As of 9/30/2020

Current valuation headwinds parallels the underperformance of 1998 & 1999

Source: FactSet October 2020. Benchmark Source: Russell Investments. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell^® is a trademark of Russell Investment Group.

**Ned Davis Multi-Cap Universe used for both charts; Left chart actual dates are 1/2/1998 to 12/31/1999 and 12/30/2016 to 9/25/2020. Right chart actual dates are 12/31/1999 to 12/29/2006 due to Ned Davis proprietary rebalance frequencies.

Post the 2000 peak, the core indices were flat to negative for the next seven years. On the other hand, domestic value indices across the capitalization spectrum generally doubled or tripled in that time period. A cohort of cheap stocks, which have been so maligned now, almost quadrupled.

We are clearly biased on this point and believe that it is always a good time to consider value investing, but now is a really good time to be a value investor. Our view is that value investing as a whole is going to outperform growth investing for a number of the reasons discussed above. Far more important for us and for our clients, however, is that we don’t have to have an opinion on that. We have a great conviction that inexpensive stocks are going to outperform expensive ones. Unfortunately, we are not going to relive the golden age in the early 2000s where you did not have to give up anything in growth or quality to buy cheap stocks. That time was a perfect storm. On the plus side, the relative gap between the inexpensive stocks to the average or expensive stock is larger than it ever has been, and you have to give up less in quality or growth than average to get that record spread. From our view on the backstretch, this cycle is going to be an exceptionally exciting opportunity for TSW and for our clients. Saddle up!

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