The reason investors continue to miss out on attractive value stocks: Our brains.
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.
Given that it's Halloween season, it seems appropriate that value stocks are starting to stage a comeback in the United States. Much like the villain in a scary slasher flick, value stocks have been beaten, battered and, by many, presumed dead. They've been losing to growth stocks since mid-2006, marking the longest stretch of imbalance in the growth/value cycle in more than three decades, Lori Calvasina, chief U.S. equity strategist for Credit Suisse, recently told CNBC. She attributes growth's lengthy run at least in part to the Federal Reserve's ultra-low-interest rate policy. With the Fed on the verge of raising rates, value plays – like a good horror story villain – are re-emerging just when everyone thinks they've met their demise.
What's really interesting is that, in theory, value investing should have been killed off a long time ago. The great Benjamin Graham, known as the father of value investing, brought this strategy to the masses more than 80 years ago when he and David Dodd unveiled the tenets of the discipline in their book Security Analysis. Numerous studies have since shown that buying value stocks is a winning strategy over the long haul. Investors who have been chasing overpriced growth stocks should have, in theory, started reallocating their funds to cheaper value plays as all of this became known, with the whole market moving toward a sort of fair valuation equilibrium.
If logistical reasons stood in the way of that transition, they should have disappeared with the rise of the Internet. Valuation information could suddenly be obtained with a few clicks on a stock screening website. The ubiquity of smartphones and social media allows investors to get reams and reams of data just about anywhere, at just about any time. Given all of the evidence that value investing, despite its recent struggles, is a winning long-term strategy, the opportunity to find cheap stocks must be getting limited as investors get better and better informed, right?
Nope. In fact, even people who invest in value funds don't take advantage of the premium that value stocks tend to earn. From 1991 through 2013, value-focused mutual funds returned an average of 9.36 per cent annually, beating the 8.38 per cent for growth funds, according to a Research Affiliates report from earlier this year. During that time, the average investor in those value funds earned an 8.05 per cent return. Alleged "value investors" weren't helping close the gap between value and growth returns – they were actually adding to the gap by ditching their funds and buying hot, expensive picks and letting cheap value stocks get cheaper. And lower prices mean better prospective returns for value stocks when the value/growth leadership switches back to value.
The reason investors continue to miss out on attractive value stocks is simple: our brains. We humans are an emotional bunch, and cheap value stocks are often cheap because fears are hanging over them. People see danger in them, so they avoid them, preferring instead to go after companies with exciting stories and rising shares, even though they may be wildly overpriced.
If you have the stomach to stick with good value stocks, however, history shows that you should come out ahead. Here's a trio of U.S. value stocks that get approval from my Guru Strategies, which are inspired by great investors who knew just how rewarding good value picks could be.
- Helmerich & Payne Inc. (HP-NYSE): My Graham-based model is high on this Oklahoma-based firm (with a market cap of $6-billion U.S.), which drills oil and gas wells. H&P trades for just 10 times earnings and 1.2 times book value and has a great balance sheet, with a current ratio of 4.3 and more than twice as much in net current assets as long-term debt. (The current ratio is a gauge of liquidity, measuring a company’s ability to pay short- and long-term debt. Anything above 2.0 is considered a sign of good liquidity in my Graham model.)
- Pilgrim’s Pride Corp. (PPC-Nasdaq): The second-largest chicken producer in the world is a favourite of the model I base on the writings of David Dreman, a renowned Winnipeg-born contrarian investor. The approach considers Pilgrim’s as a contrarian value play because both its price-to-earnings and price-to-cash-flow ratios are in the market’s cheapest 20 per cent. The firm (market cap $5-billion) also has a stellar 59 per cent return on equity and a debt-to-equity ratio below its industry average.
- Gilead Sciences (GILD-Nasdaq): This biotech company ($158-billion-market-cap) focuses on patients suffering from life-threatening diseases such as HIV/AIDS, cancer and cardiovascular conditions. You may not consider a biotech a likely value pick, but its earnings yield (earnings before interest and taxes divided by enterprise value) is a dirt-cheap 12.4 per cent, impressing the model I base on the writings of Joel Greenblatt, a highly successful hedge fund manager. The strategy also likes Gilead’s 102 per cent return on capital.
I'm long HP, PPC and GILD.
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.