The Compound and Friends - Why Value Investing Will Never Die

Episode Date: May 14, 2020

Josh Brown and Michael Batnick discuss the recent rash of commentary about the "Death of Value Investing," a discipline that has already died a thousand deaths before and yet is continually resurrected. Michael points out that growth investing is currently on a 30-year win streak versus value investing, while the distance between cheap stocks and expensive stocks has never been more stretched. Josh's take is that the idea of buying an asset for less than it's worth is immortal, but the inputs we base these decisions on might need to change. Perhaps it's not a problem with the concept, but with the measurements.  You can find more of Michael's thoughts and charts on the topic at his post below: https://theirrelevantinvestor.com/2020/05/12/the-case-against-value-investing/  You can find Josh's written rant on value investing here: https://thereformedbroker.com/2020/05/12/value-investing-is-immortal/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi, guys. It's Downtown Josh Brown. I'm here with Michael Batnick. We are here to talk about the financial industry topic du jour, the death of value, part 970. Value investing has underperformed growth investing over the last 1, 3, 5, 10, and 30-year periods, which means a comeback is going to start any minute now, or maybe not. Let's talk about it. Welcome to the Compound Show podcast. Each week, we let you in on some of the best conversations we're having about markets, investing, and life. Just a quick reminder, the hosts of the show are employees of Ritholtz Wealth Management. All opinions expressed are solely their own opinions and do not reflect the opinion of Ritholtz Wealth.

This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast. Okay, here we go. discussed in this podcast. Okay, here we go. Okay, Mike, everyone's talking about the death of value investing. And I mentioned this morning, I feel like we do this once a year for a few weeks, and then the season ends, and then we do it the next year. What's different now? Well, we won't we won't do it if it starts if it starts working. And we won't have this

conversation. Obviously not going to start working ever. But why does this topic continue to beguile the chattering classes? I think right now it's very simple. We were told by various people that in the next recession and the next bear market, value would hold up better, at least coming out of the recession. Obviously, we're still in it. So maybe that's not a fair thing to say. But the opposite has happened. The stronger have gotten stronger. The growth have gotten growthier. The opposite has occurred. Right. So in other words, there were people who were weighting portfolios based on value because they thought that value stocks would provide a margin of safety in a general market drawdown. And actually, the opposite has come true. Buying low and multiple stocks didn't help anybody. So the second part of that is why

are we talking about it? Well, because as a result, value is struggling heading into this. As a result of the difference in returns, whatever spread you're looking at, earnings yield, price to free cash flow, whatever, based on any metric, value is as cheap as it's ever been relative to growth, including the dot-com bubble, which is pretty wild to think about. Okay. So you're saying in your post this morning, you're saying over the last 10 years, for example, in your post this morning, you're saying over the last 10 years, for example, large cap value compounded at 8.7%, which is not terrible. But large cap growth compounded at 15%, which is a six and a half percent annualized spread of performance,

which rivals the dot com bubble, period, like it's, it's a wild, wild spread. It's very rare to see one discipline trail the other to such an extreme. Right now, we're talking about spreads in performance. What Cliff and O'Shaughnessy did is they're talking about the spreads in valuation. So that is at an all-time gap. And now if we're talking about is value dead, you obviously have to define what do you even mean? What are you talking about? Is value dead? Because what you wrote, the idea of buying a stock, buying $1 worth of earnings for 75 cents, how could that ever die? That's what it means to invest. But the idea that buying statistically cheap companies, again, however you want to rank them, whatever your preferred ratio is, is that style, systematic value investing, is that dead? And I think you have to at least be open-minded to the fact that maybe it is. Yeah, you have an input. You don't

have a problem with value investing. So I so i said value investing is immortal and i and i and i believe that um anytime somebody is looking for something that's cheaper now than it will be in the future is is value investing so the the people like joel greenblatt and warren buffett who say all investing is value investing i think that's right. So what is the problem? The problem is the inputs, the things that we're using to determine statistical value. That's the issue because that's the stuff that really doesn't matter anymore. It doesn't matter to investors. It doesn't matter to profitability. It doesn't matter really to anyone. So this idea that- So let me throw this at you. So Robin Wigglesworth did a post just sort of summarizing what's been going on. And Bob Wyckoff, a managing director of Tweedy Brown said, you go through some uncomfortably long

periods where it is not working. 30 years. But this is almost a pre- 30 years. This is almost a precondition for value to work. Actually, since inception, growth is now winning. So that goes back to 1979. And I guess the question is, again, getting back to systematic value investing, is that the right way to capture value? And I went back to a post that was done, factors from scratch. Chris Meredith, Patrick O'Shaughnessy, and Jesse Livermore did this incredible post where they decompose where the returns actually come

from. And they said, the value factor generates its returns almost entirely through multiple expansion. The contribution from earnings growth in the underlying companies is negative in almost every single year. So that's what happens. These are shitty companies relative to the apples of the world, of course. In general. shitty companies relative to the apples of the world, of course. In general. So now the question is, have investors collectively gotten so good at pricing these lousy companies? Now, somebody said to me on Twitter, well, how do you explain Virgin Galactic and all the stocks that are trading at a billion times earnings or whatever it is?

I think it's always really hard to value growth stocks. I think you always overpay for a basket, generally speaking. But maybe investors have gotten really good at pricing companies with little to no earnings growth. Is that possible? I mean, it's theoretical because we're talking about something in the aggregate and anyone that wants can listen to an answer to that and then say, oh, yeah, but what about this one-off example that occurred to me? So it's really hard. What I said in my post about that issue is the best time to buy a value stock is when the company is about to get its shit together and learn how to start growing earnings again. That's how you

make money in value. Apple was a 10 multiple five years ago. Nobody wanted it. They said, this is consumer electronics. It's the worst portion of the technology space. Is anything selling consumer electronics? Therefore, price it at 10, X cash, nine, nine times earnings. And then it went to 21. Why? Services growth. iPhone 10, iPhone 10S or whatever, iPhone 11. So in other words, it was a value stock. It didn't have a lot of growth. iPhone 10, iPhone 10S or whatever, iPhone 11. So in other words, it was a value stock.

It didn't have a lot of growth. And then all of a sudden it hit a growth streak. That happens with companies. It doesn't happen with every company. So if you want to make money in value stocks, this is my opinion. You could say, whatever, here's my formula. Put the formula aside. Try to come up with a reason, a reason why a cheap company all of a sudden is going to start growing again. And then use the chart. Buy it on a breakout. Why is it so controversial? In other words, okay, the whole world agrees this is a cheap stock.

It doesn't make a difference if it stays cheap. Tell me when it stops staying cheap. Then I'm interested. Tell me when it's breaking out. Well, yeah, obviously. That's like saying only buy the good stocks. Everybody knows that. Here's why people have trouble doing that.

And I would have trouble too. I don't think I could do it either. Here's why. I judged a stock picking competition once, college students at a college in Michigan. One team had a kick-ass presentation. I forget what stock they were presenting. But then they did something where they said, we combine the fundamentals with the technicals.

So we're looking for very cheap stocks and we think this stock is cheap and we want to buy it when it's trending higher. So then they were like, I was like a judge. And so I asked a very innocent question. What do you do when the fundamentals and the technicals disagree with each other, which happens, I don't know, every day of your life? What do you do when you know it's a cheap stock and a good company, but it's trending down? What do you trust? Do you trust the chart and stay out? Or do you trust the fundamentals and buy? I would have trouble with that. College kids couldn't answer my question. I think they changed the subject. But to me, that's a better framework to try to figure out when is a value stock going to become a growth stock again.

But the problem is that's not repeatable. It's not, I mean, it's a very loose framework. You need to have a process. So here's what O'Shaughnessy and Meredith and Jesse said. Certain stocks on the market are experiencing weakness in their fundamentals. Obviously, that's how they become value stocks in the first place. The market is detecting the weakness and reacting to it by pricing the stocks very cheaply relative to current earnings, which are not expected to be sustained, right? Nothing controversial there. The value factor is buying into the stocks at the very cheap prices and holding them for a one-year period. During that period, the fundamentals end up coming in weak as expected, but the market, which is looking farther out into the future, becomes less pessimistic about the stocks and re-rates them

higher, lifting their prices and valuations. The strategy repeats this process over and over again. Of course, in theory, that's how it's supposed to work. You're saying the company's fundamentals don't improve. The market just decides that they're worth a second look and gives it a higher multiple? No, no, no. Yes. There is no EPS growth in these companies. However, they come in less bad than expected. So the multiple gets re-rated higher and that's where the return is generated from. So – Well, so how do you time that? How do you time when the crowd is going to fall back in love with a stock that's had no improvement in its business?

Who says you should? I don't think you can. Well, that's what the turnover inside of the strategy is doing for you. You're not supposed to be able to figure that out. So I think that there are really good points on both sides. I don't know that I feel feel much more comfortable saying the inputs are garbage. They don't work anymore. All right.

What about this? When I say it's an input problem, what if all of a sudden value investors start to pivot to different ways of assessing value and start making money as a result of that. So what if they say, okay, I understand that this textbook I read 30 years ago told me that value is some function of either earnings, you know, recurring earnings stream or the assets of the company minus their debt. But how else do you value? How else do you value? Yeah.

What if we decide that there are things that are more important and some of them can be quantified? Yeah. Like what? I don't know. User growth, recurring subscription revenue, like the things that people actually are paying But those are not value stocks. Those are growth companies.

Okay. But there are successful people who have been known for their value investing that have bought Amazon and they do all these mental gymnastics to try to explain to shareholders that, no, I'm not getting away from my discipline. I'm just being an adult and I'm recognizing that the world has changed and I'm putting the textbook to the side. I'm not throwing it in a bonfire. I'm just saying, holy shit, it turns out not everything written in a book in 1940 is applicable to the way the

world actually works in 2020. And I'd like to keep my career as an investor, rather than be a martyr to a philosophical discipline that is dwindling in importance with every passing year. Like that's happened before. We've seen people do that. So I think this last point is important. If we're talking about a 30-year period that growth has outperformed value, can we at least point back to the fact that during that 30-year period, there have been three, five, and seven-year stretches where value has done better than growth?

Of course. Of course. It's not dead. It's never going to die. But let's just accept the fact that systematically, it just may not be the case that value outperforms growth. It may also not be the case that growth outperforms value. The answer to that question is a function of when you're doing the measuring from. When you're doing the measuring from. Because in 2002, it was obvious that value over the long term does better than growth because of how disastrous

the dot-com crash was for growth stocks and how comparably weak the sell-off was in other stocks, value stocks, core stocks. So it's where you're measuring from. I keep going back and forth because is it not the case that investors will always, in the aggregate, overpay for growth? Isn't that just a fundamental part of investing? A basket. Now, of course, there's individual winners. The biggest winners are in that basket. But as a basket, individuals will overpay for growth. That just hasn't happened in the last 10 years. So things are different today, obviously. Let me ask you a question. Hold on. Let me finish the question. Things are different today? Obviously, are they different? Hold on. Let me finish the question. Are things different today? Are they different forever? Is that permanently changed?

I don't know. It's tough because I'm like you. I go back and forth. But what I wanted to ask you about what you just said, if I tell you two years from now, Netflix will be trading at 10 times earnings. Do you want it? No way you don't want it. Because why is it trading at 10 times earnings? It's trading. It's there because it's a substantial existential threat to either its competitive position or its business model. You don't want to grow a stock at

a value multiple. Okay, fine. Fair enough. Can't you see a scenario in five years where we're like, of course value is outperforming. You were paying 75 times 2025 earnings for Twilio. That wasn't sustainable. Can you easily picture a world where that conversation is happening? Totally, which is why I think we have to acknowledge there are periods that value does better. And it's a function of like, whichever one, the one that looks invincible is the one that's just had an incredible five-year streak right before you're about to take that measurement. And then we rewrite the whole story. It just so happens, however, that it is a very long stretch where low price book, low price earnings, et cetera, has not paid investors, like excess returns. Maybe the lesson is don't go all in

on any analytical factor, any style of investing. Be open-minded to the fact that there are other things at work other than what you've adopted. I so totally agree with that. And I also think that there are people right now either tinkering with quantitative screening or doing fundamental research differently than it's been done that are value investors. They're going to come up with whole new ways to assess value that maybe don't appear in prior quantitative versions, but they will be seen as, quote, the new value investors. And their formulas will be taught in schools to future investors. So it'll be value investing that is not deriving value from any of the SEC filings. You might just need new inputs and value investing lives for another thousand years. There's no reason.

There's no reason. As soon as we say financial statement analysis is dead, it'll live again. It's not that it's dead. It's that everyone's doing it already. I mean. But if everyone was doing it, then why are the multiples higher? How come the spreads are as wide as they've ever been if everyone is doing something? There's more money in the market, but that's a different conversation.

All right, listen, what do you guys think? Is it dead? Is it about to make a comeback? If the 30 years of underperforming has the mean reversion started now with us publishing this video, is this the bottom for value versus growth? You could tell us. We can handle it. Go ahead and give us a like.

Subscribe to the channel. Stick around. We'll be back with something new very soon. Thanks for listening. Check us out at thecompoundnews.com for daily investing and market insights. You can watch all of our videos at youtube.com slash thecompoundrwm. Talk to you next week.