Warren Buffett was once a value investor. Now he’s buying big tech. Merryn Somerset Webb asks Lyrical Asset Management’s Andrew Wellington: “Where’s the real value now?”
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?”
“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”.
Those who like to look for signals that the tech bull is topping out (or at least entering its last gasp) might even want to go so far as to say that this apparent capitulation by Buffett, a man once thought of as the greatest value investor ever, is the best contrarian signal we will ever get that it is time to switch out of growth stocks and into value stocks.
Value stocks have done better than you think
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.
A good year for value so far
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.”
Is it time to buy?
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”.
“This is the best opportunity for value investors 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.
Three of the best value funds to buy
In the UK you might look at the Aurora Investment Trust (LSE: ARR). I have a (moral) objection to the housebuilders in the portfolio, but manager Gary Channon has long been inspired by the old-style Warren Buffett, so his portfolio is very value-biased (no Amazon).
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 before but 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.
In Japan meanwhile, MoneyWeek regular and founder of Price Value Partners, Tim Price (who does look at p/b when judging value, but fully accepts its limitations – see below – and so also focuses firmly on low p/e firms and on cash flow measures), suggests you look at the Samarang Japan Value Fund, managed by Jan Pstrokonski, which invests in undervalued small- and mid-cap Japanese companies.
Getting the measure of value
The idea of the Russell 1000 Value Index is to reflect the performance of “value” stocks in the Russell 1000 Index, which in turn is supposed to represent the market as a whole. However, look closely at the 1000 Value and you will see that it has 725 stocks in it – so not far off three-quarters of the Russell 1000.
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.
Another reason why p/b is less useful than it once was is because a variety of accounting changes have reduced the extent to which book value can accurately reflect intrinsic value (assets that were written down during the financial crisis have not been written up since, for example). The rise in share buybacks also complicates matters.