Stocks of growth companies such as Netflix get a lot of attention but being trendy also means growth stocks are prone to attract investors with high expectations.Chris Ratcliffe/Bloomberg
John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
Netflix Inc. looked about as perfect as could be. In 2015 alone, the stock was up 134.3 per cent. Analysts had it on a trajectory to achieve a $100-billion (U.S.) market capitalization by the end of the decade. But recently the tech darling had a disappointing announcement: The growth of its streaming video service had slowed significantly. Its shares instantly shed 16 per cent and so far in 2016, the stock has lost almost 25 per cent of its value.
Stocks of growth companies such as Netflix get a lot of attention because they have the potential to soar. But being trendy also means growth stocks are prone to attract investors with high expectations. Some of these investors are placing bets purely on emotions, with the hope to have a repeat of 2015 type of returns, while others are piling on because the stock is exhibiting strong price momentum.
Value stocks, on the flip side, are by comparison far less exciting. Their stocks trade at a discount, and as established companies that grow relatively modestly, they rarely have the same headline-grabbing returns.
It may surprise some that a study by Bank of America shows that value stocks outperformed over a 90-year period from 1926. Annual returns over that period were 17 per cent for value stocks versus 12.6 per cent for growth stocks.
Value stocks tend to outperform during good economic times, Bank of America showed. Growth stocks have done better during periods of economic weakness. And over nearly one century, the good times have come more frequently than the bad.
Still, since the end of the financial crisis, growth stocks have outperformed value stocks by a wide margin. One reason could be that historically low interest rates have made access to capital cheaper for growth companies to hire and expand. Another could simply be overheated expectations for some companies.
So far this year, value stocks have the edge. The iShares Standard & Poor's 500 Value ETF, which holds large cap stalwarts Bank of America, Chevron Corp. and Merck & Co. Inc., is up 9.35 per cent year to date, while the iShares S&P 500 Growth ETF, which holds Apple Inc., Facebook Inc. and Alphabet Inc., among others, is up 5.4 per cent.
Stocks that are priced for perfection have to deliver or they risk losing a painful amount. Value stocks, however, are not priced for perfection. They usually have something off about them. The market is overly concerned with some aspect of the company's business or overlooking positive signs.
With low expectations for value stocks, any whiff of momentum can send their valuations rallying.
Investors are also impatient, ready to dump a stock at the latest shift in sentiment. Patience is something Warren Buffett has long prescribed. It's easy enough to find the cheap stocks, but the benefits of holding them come only over the long term. This approach is backed up by research from Merrill Lynch, which found that to secure the benefit of buying low, investors have to wait 10 years. Cheap has little effect on return for those who invest only for a year or two.
Value investing guru Benjamin Graham studied company balance sheets and fundamentals, ignoring the flash and the hype. He looked at sales numbers and debt, and the difference between a stock's price and the value of the business. Not surprisingly, he focused on stocks that had a high degree of difference between these two numbers. Being cautious has its advantages. Bargain-basement stock prices have significant downside already built into them.
I pick stocks using strategies I developed based on the published approaches of Mr. Buffett, Mr. Graham and other Wall Street gurus. My Value Investor portfolio, which is based on Mr. Graham's strategy, has some suggestions:
Fossil Group Inc. (FOSL), the maker of consumer fashions and accessories under labels such as Fossil, Diesel, Adidas and Burberry, has a price-to-book of 1.5 and a 20-per-cent return on equity. The shares have also sold off recently, making it a bargain in the eyes of my Graham-based strategy.
Innospec Inc. (IOSP), an Englewood, Colo., maker of fuel additives and oil field chemicals and another top pick of the strategies that track the styles of Mr. Graham and James O'Shaughnessy, an expert on quantitative investment strategies. It has a price-to-earnings ratio of 13, which the Graham model likes, and a 1.25 price-to-sales ratio, which the O'Shaughnessy model likes.
Dillards Inc. (DDS), the Little Rock, Ark., department-store chain is also a top Graham portfolio pick. At $63, the stock is trading near its 52-week low of $54. It has a price-to-earnings ratio of 10 and has more net current assets ($983-million) than long-term debt ($820-million), impressing the Graham model.
Disclosure: John Reese is long shares of Dillards, Innospec and Fossil.