In our recent article, The Value Rotation Illusion, we explained that in the recent rotation from growth to “value”, passive investors, in actuality, are selling value stocks to buy expensive stocks. Confused? In this follow-up, we take our three-tier earnings valuation framework introduced in the article a step further to uncover true value stocks.
First, though, it’s vital to provide context for why the passive investment landscape skews stock valuations.
Passive Investing Drives The Current
A passive investment environment is oftentimes agnostic to valuations, blurring the lines between traditional investment styles like value and growth.
Oftentimes, we associate passive investors with investing in broad market indexes such as the S&P 500 or the Nasdaq. However, passive investors also buy sector- or factor-based ETFs, such as consumer staples ETFs or large-cap growth factor ETFs. The word “passive” means they are not picking individual stocks, but it doesn’t necessarily imply their investment style is passive. A growing number of passive investors are actively trading, rotating in and out of popular narratives and themes. For more on the topic, please read our recent article Calm Market Waters Hide Fierce Undercurrents.
For instance, over the last few months, stocks in large-value ETFs have been hot, while the once-trendy mega-cap technology stocks have fallen out of favor. We can easily see this rotation in the performance differences between value and growth ETFs and sectors, as well as in the money flows into and out of the largest ETFs.
The first graph below shows the stark contrast in money flows from the Vanguard large-cap value (VTV) and the iShares large-cap growth (IVW) ETFs. The second graph shows a greater divergence between the State Street Energy ETF (XLE) and the State Street Technology ETF (XLK). The data in the graphs is courtesy of ETF.com.
The Value Rotation Narrative
The media is making quite a to-do about the exodus from “expensive” growth stocks into “cheaper” value stocks. Yet as we showed in Part One, investors are chasing a narrative. In many cases, investors are selling value while believing they are buying it.
The value rotation narrative can be summarized as follows: Higher-beta, mega-cap growth stocks have run their course and are now expensive and risky. Therefore, the logical place to rotate to is toward the opposite, less expensive, smaller-cap, and value sectors.
Regardless of whether the narrative makes sense, it is driving the markets, the sectors, and the factors beneath them. Thus, while we can tell you all day that many value ETFs do not represent value, it doesn’t matter. The narrative will trade patterns until it fades.
However, if the narrative is not factual, it will create distortions. Therefore, active investors must appreciate the narrative and its current impact on market dynamics, but also be able to find true value stocks, for their day in the sun will come.
Traditional Screens Miss Real Value
Most value investors begin their search with quantitative screens using filters such as low P/E ratios, high dividend yields, or low price-to-book multiples. These metrics are useful starting points, but they are not conclusions. In many cases, they simply identify companies that appear cheap.
“Cheap” valuation metrics, like those mentioned above, can signal problems rather than opportunities. For example:
- Earnings may be cyclical and near a peak.
- The business model may be deteriorating.
- Management execution may be inconsistent.
- A legal, political, or structural headwind is forming.
Many screens, especially those that don’t use forward-looking estimates, cannot distinguish between undervalued and declining companies. As a result, investors often confuse statistical cheapness with genuine value.
A Forward-Looking Framework
To properly evaluate value, investors must view companies through multiple valuation lenses. Each lens answers a different question, and when the three align, value opportunities are much more likely to emerge.
The three valuation lenses are past, present, and future. Does the company have a good earnings track record? Is it currently performing at a high level? Is it expected to grow solidly in the future? Importantly, it’s not just about earnings; equally important is how the current price relates to its past, present, and potential earnings.
Past Earnings
Is the stock obviously expensive based on its earnings and cash flow over the last year or two? Metrics such as trailing P/E, free cash flow yield, and margins help answer that question.
One Year Forward Earnings
Forward estimates matter more than trailing ones, but only if they are believable. As Benjamin Graham advised:
Investors should limit analysis of the future to what can reasonably be foreseen.
Companies with predictable financial trends, durable competitive advantages, and consistent execution deserve more confidence than those dependent on optimistic assumptions, economic scenarios, or speculative growth narratives.
Growth Adjusted Valuations
As we discussed in the first part, P/E ratios and forward P/E ratios can be expensive if expected growth is expected to ramp higher. That is why we also use the PEG ratio, which compares a company’s valuation to its expected growth rate.
This third step is missing from the screening process for many investors. It is also the most difficult, as small changes in growth assumptions can dramatically alter whether a company qualifies as a value stock.
Applying The Framework
In Part One, we noted that companies like Walmart and Costco, which many investors consider tried-and-true value stocks, are not cheap. Using the three-tiered framework we detailed above, Walmart has a P/E of 46, a Forward P/E of 43, and a PEG ratio of 4.50. It is clearly expensive based on the three lenses.
To help true value investors look beyond expensive “value” stocks and find true value, we created a stock screen. The results shown below have low valuations, good earnings outlooks, and growth prospects that justify their prices. These are the companies that most closely resemble true value stocks in today’s market, but they are not without risk.
We screened for the following attributes:
- Market Cap: > $5 billion
- Country: USA
- P/E: <15
- Forward P/E: <15
- PEG Ratio: <1.0
- Price to Sales: <1.0
- Quick Ratio <1.0
In addition to our three lenses, we added the price-to-sales ratio to further affirm value, and the quick ratio to help assess financial liquidity for the companies. Further, we removed financial stocks, as earnings-based analysis is not comparable to that of most other companies.
Why True Value Is Often Ignored
Markets are influenced by fundamentals but more so by psychology and incentives. Professional managers frequently prefer widely owned stocks because deviating from benchmarks introduces career risk. Furthermore, passive investment vehicles allocate capital according to index weightings that loosely fit the fund’s objective. Doing so reinforces the dominance of already-popular, large companies. At the same time, the financial media often amplifies compelling narratives, drawing even more capital toward the same group of stocks.
These processes often produce a feedback loop. Popular companies attract inflows, which push prices higher, which in turn attract more inflows. Less fashionable companies experience the opposite dynamic, even when their earnings and balance sheets remain solid. Accordingly, the valuation gap between favored and ignored companies can widen significantly.
To wit, on our screen, the stocks are not big contributors to popular ETFs. For example, Phillips 66, the largest company on our screen, accounts for only 3.78% of the XLE energy ETF. Delta and United, the next-largest companies, account for 0.86% and 0.67% of the XLI industrials ETF, respectively. Those companies comprise an even smaller percentage of the largest large-cap value fund (VTV).
The Value Trap
One of the most persistent misconceptions in investing is that “cheap” stocks, like the ones we shared above, qualify as a value stock. In reality, the most dangerous category of stock is one that appears cheap but lacks the earnings power, growth potential, or poses other significant risks to justify its discounted valuation.
For example, Delta and United Airlines appear on our screen as true value stocks. But the future revenues for both companies are highly tied to the economy and jet fuel prices. Moreover, credit card rewards programs are a significant contributor to their earnings. If we forecast a recession, their estimates for double-digit earnings growth are bunk. We should also consider how the current surge in jet fuel prices will affect costs and whether they can pass them on to consumers. Further, will increased competition from non-traditional credit card companies sway users away from Visa- and MasterCard-backed airline reward credit cards?
True value requires both a reasonable price and viable earnings and earnings growth. The higher your confidence in the earnings growth of a value stock, the better your odds of success!
Summary
True value investing has never been easy. But today’s passive investment environment has made it much more difficult. For example, a growing number of value investors buy value in name only. ETFs using the word “value” attract so-called value investors. At the same time, fewer and fewer investors are truly seeking out true value stocks. The result can be a stark divergence in the fortunes of perceived value and true value stocks. Ultimately, such market behaviors create incredible opportunities, but we warn that patience is required to wait for such differences to correct.
