Forget Buffett: if it’s value stocks you want, here’s what to buy

published 9 May 2019

946_MW_P26_Interview — Warren Buffett: has he changed his style?

If there is one thing I really hate, it's the cutesy business of having a sweet child ask a question at the Berkshire Hathaway love in/AGM. The year I went, one asked a question in the form of a poem. The firmly cynical Brit part of my brain has managed to expunge the detail but the gist (with more in the way of lousy rhymes and bad scanning) was: "Oh Warren, you're so wonderful, how can we all be more like you?" Ick.

This year, however, the questions were, as one newspaper put it, slightly "sharper" than usual. Why? Partly because Berkshire Hathaway has been underperforming the market for a while now, partly because it is holding a large ($114bn) pile of cash (shareholders hate that if you can't figure out how to use cash, why not give it back?) and partly because the firm, famous for its long-term value philosophy, has just bought a large pile of shares in Amazon. This makes no sense whatsoever, Bill Smead of Smead Capital told the Financial Times. Buffett is forever telling people to be fearful when others are greedy, and greedy when others are fearful. "Amazon has 45 analysts that cover the stock: 45 buys, zero neutrals, zero sells." It might be growing more slowly and making a tad more money than it was. But "how is buying the most popular stock on the planet being greedy when others are fearful?"

Good question, you might say. So do we. You might also ask what a value investor is doing even looking at the tech sector (Berkshire also holds Apple, which means he owns two of the FAANG stocks, the others being Facebook, Netflix and Google/Alphabet) when so many valuations suggest that we are in the middle of yet another great technology bubble. Right now, says Julien Garran of MacroStrategy Partners, there are 30 stocks in the S&P 500 trading on ten times their revenues or above. Look at prices like that, says Garran, and you might think that investors (just as they were in 1999), are "seeing the performance of the FAANGs, reverse engineering a fundamental justification for why it is happening, and then using that justification to buy the stocks".

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Andrew Wellington, the founder of US-based Lyrical Asset Management, would certainly agree. I met him at the Alliance Trust AGM in Dundee a few weeks ago (Lyrical is one of the fund managers the trust has hired to run focused portfolios for it see my previous post here). Some people think the whole idea of value investing is "broken," he says. He doesn't. Instead he thinks that right now could actually represent "the greatest value opportunity in a generation". That needs a little unpicking, doesn't it? The place to start is with definitions.

Most US investors use the Russell 1000 Value Index, which includes firms with lower price-to-book (p/b) ratios and lower growth forecasts than the market average (see box opposite) as their proxy for the behaviour of the value strategy, something that suggests the strategy has underperformed for the last one, five, ten and 15 years. Wellington does not. He reckons the best way to define "value" stocks is not to look at the Russell 1000 Value, but instead to look only at stocks with low price/earnings (p/e) ratios.

Do that and you will see that "value" has generated returns in the US of 813% since 1998 against 328% for the value index (and 336% for the more general S&P 500). Since 1998 the lowest quintile of stocks by p/e have outperformed the S&P 500 by nearly four percentage points a year (up 11% a year against 7.2%) and since 2009 they have done so by a good two percentage points a year (16.3% vs 14.2%). The last few years have not been so good thanks in the main to genuinely awful performance in 2018 when the lowest quintile of stocks in p/e terms lost a nasty 15.2% against a mere 4.4% for the S&P 500 (and only 2.8% for the highest quintile by p/e). Lyrical's funds had a horrible year as well losing more like 20% in 2018.

Still, use Wellington's definition and you could hardly say that the strategy doesn't have a history of working long term. Nor could you say with any confidence that it won't soon be back on top. This year has started pretty well: when I met Wellington two weeks ago, low p/e stocks were up 18% on the year already seven percentage points more than the S&P as a whole, although most of those gains had been made in the first few months of the year.This rather fits the long-term pattern of behaviour of this type of stock: "Long stretches where low p/e outperforms significantly and then short periods where it acutely underperforms," says Wellington. A case in point were 1998 and 1999. In the last two years of the great internet bubble, value stocks underperformed by 57%. They then had an absolutely "glorious run" for the next 14 years (the down cycle began in 2014, and 2015 was a rotten year for value). That does not mean the turn has come, of course. "It is not uncommon for stocks to make a bottom, recover and then test that bottom again before recovering."

So, should you start getting into value now (regardless of the risk of another leg down)? If you are planning to be in the equity markets at all, then yes, you certainly should: Wellington tells me all of his own money is invested in his own value funds. The absolute levels of the p/es of the cheapest stocks are still "well below historical norms"; the spreads (that is, the difference) between them and overall average valuations are "unusually wide and have only been like this twice before: at the end of the financial crisis and at the end of the internet bubble". The truth, says Wellington in a note on the details, is that "on any reasonable interpretation of the data" this is the "best opportunity for value in a generation".

Not broken, but misrepresented? It rather looks like it. UK investors can't get access to Wellington's investing ideas in the UK except via Alliance Trust (where the holding will be one of eight, and so rather diluted given that those eight include several growth-orientated portfolios too). But for those interested in individual stocks, he did tell me about a couple of his favourites. First up is Hospital Corporation of America (NYSE: HCA), America's largest public hospital company (think 179 hospitals and 1,200 outpatient facilities). It is stable and growing. One of its strongest years ever was 2018. Lyrical thinks it can grow earnings per share at 13% or so a year for the next few years yet the shares are currently on a p/e of only 13. Another to look at might be Broadcom (Nasdaq: AVGO), a diversified semiconductor and software company. It is highly profitable (30% operating margins) with a strong balance sheet (it holds cash to the equivalent of 12% of its current market capitalisation) and the shares trade on a p/e of 12.

In the US, you might look at the Arbrook/G10 American Equities Fund run by Robin Milway. Milway considers himself to be a value investor in the tradition of Philip Fisher and (original) Buffett. But he adds to this a new dimension he calls "latency" or mispriced growth potential. We've written about this fund beforebut put simply, one example of latency is the idea that the productive capacity of many "old world" businesses is being transformed by digitalisation, and as such, many of these companies have latent potential growth that most investors are currently overlooking.

That makes it more of an index that excludes the most expensive stocks, rather than focusing on the least expensive (as you'd expect from a measure of value stocks). The index also uses price-to-book (p/b) as the main factor to determine value. P/b has long been used by academics for this purpose (and we often use it at MoneyWeek). However, Andrew Wellington of Lyrical Asset Management reckons the ratio has had its day.

That's partly because in today's information economy, and given the high value of intellectual property relative to hard assets, the value of hard assets (factories and the like) no longer captures the value of a company in the way that it once did. Take fast food giant McDonald's. John Stepek noted in the magazine a few months ago that the brand itself is valued on the balance sheet at $2bn, but brand analysts actually reckon it is worth more like $40bn.

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.