Tag Archives: value

Earnings Lies & Why Munger Says “EBITDA is Bull S***”

Earnings Worse Than You Think

Just like the hit series “House Of Cards,” Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C.

What is most fascinating is that so many individuals invest hard earned capital based on these manipulated numbers. The failure to understand the “quality” of earnings, rather than the “quantity,” has always led to disappointing outcomes at some point in the future. 

As Drew Bernstein recently penned for CFO.com:

“Non-GAAP financials are not audited and are most often disclosed through earnings press releases and investor presentations, rather than in the company’s annual report filed with the Securities and Exchange Commission.

Once upon a time, non-GAAP financials were used to isolate the impact of significant one-time events like a major restructuring or sizable acquisition. In recent years, they have become increasingly prevalent and prominent, used by both the shiniest new-economy IPO companies and the old-economy stalwarts.”

Back in the 80’s and early 90’s companies used to report GAAP earnings in their quarterly releases. If an investor dug through the report they would find “adjusted” and “proforma” earnings buried in the back.

Today, it is GAAP earnings which are buried in the back hoping investors will miss the ugly truth.

These “adjusted or Pro-forma earnings” exclude items that a company deems “special, one-time or extraordinary.” The problem is that these “special, one-time” items appear “every” quarter leaving investors with a muddier picture of what companies are really making.

An in-depth study by Audit Analytics revealed that 97% of companies in the S&P 500 used non-GAAP financials in 2017, up from 59% in 1996, while the average number of different non-GAAP metrics used per filing rose from 2.35 to 7.45 over two decades.

This growing divergence between the earnings calculated according to accepted accounting principles, and the “earnings” touted in press releases and analyst research reports, has put investors at a disadvantage of understanding exactly what they are paying for.

As BofAML stated:

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power. 

Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant, and since 2013, the number has been on a steady rise.

So, why do companies regularly report these Non-GAAP earnings? Drew has the answer:

“When management is asked why they resort to non-GAAP reporting, the most common response is that these measures are requested by the analysts and are commonly used in earnings models employed to value the company. Indeed, sell-side analysts and funds with a long position in the stock may have incentives to encourage a more favorable alternative presentation of earnings results.”

If non-GAAP reporting is used as a supplemental means to help investors identify underlying trends in the business, one might reasonably expect that both favorable and unfavorable events would be “adjusted” in equal measure.

However, research presented by the American Accounting Association suggests that companies engage in “asymmetric” non-GAAP exclusions of mostly unfavorable items as a tool to “beat” analyst earnings estimates.

How The Beat Earnings & Get Paid For It

Why has there been such a rise is Non-GAAP reporting?

Money, of course.

“A recent study from MIT has found that when companies make large positive adjustments to non-GAAP earnings, their CEOs make 23 percent more than their expected annual compensation would be if GAAP numbers were used. This is despite such firms having weak contemporaneous and future operating performance relative to other firms.” – Financial Executives International.

The researchers at MIT combed through the annual earnings press releases of S&P 500 firms for fiscal years 2010 through 2015 and recorded GAAP net income and non-GAAP net income when the firms disclosed it. About 67 percent of the firms in the sample disclose non-GAAP net income.

The researchers then obtained CEO compensation, accounting, and return data for the sample firms and found that “firms making the largest positive non-GAAP adjustments… exhibit the worst GAAP performance.”

The CEOs of these firms, meanwhile, earned about 23 percent more than would be predicted using a compensation model; in terms of raw dollars. In other words, they made about $2.7 million more than the approximately $12 million of an average CEO.

It should not be surprising that anytime you compensate individuals based on some level of performance, they are going to figure out ways to improve performance, legal or not. Examples run rampant through sports from Barry Bonds to Lance Armstrong, as well as in business from Enron to WorldCom.

This was detailed in a WSJ article:

One out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings.”

This rather “open secret” of companies manipulating bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to flatter earnings is not new.

The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

Manipulating earnings may work in the short-term, eventually, cost cutting, wage suppression, earnings adjustments, share-buybacks, etc. reach an effective limit. When that limit is reached, companies can no longer hide the weakness in their actual operating revenues.

There’s a big difference between companies’ advertised performance, and how they actually did. We discussed this recently by looking at the growing deviation between corporate earnings and corporate profits. There has only been one other point where earnings, and stock market prices, were surging while corporate profits were flat. Shortly thereafter, we found out the “truth” about WorldCom, Enron, and Global Crossing.

The American Accounting Association found that over the past decade or so, more companies have shifted to emphasizing adjusted earnings. But those same companies’ results under generally accepted accounting principles, or GAAP, often only match or slightly exceed analysts’ predictions.

“There are those who might claim that so far this century the U.S. economy has experienced such an unusual period of economic growth that it has taken analysts and investors by surprise each quarter … for almost two decades. This view strains credulity.” – Paul Griffin, University of California & David Lont, University of Otago

After reviewing hundreds of thousands of quarterly earnings forecasts and reports of 4,700 companies over 17 years, Griffin and Lont believe companies shoot well above analysts’ targets because consistently beating earnings per share by only a penny or two became a red flag.

“If they pull out all the accounting tricks to get their earnings much higher than expected, then they are less likely to be accused of manipulation.” 

The truth is that stocks go up when companies beat their numbers, and analysts are generally biased toward wanting the stock they cover to go up. As we discussed in “Chasing The Market”, it behooves analysts to consistently lower their estimates so companies can beat them, and adjusted earnings are making it easier for them to do it.

For investors, the impact from these distortions will only be realized during the next bear market. For now, there is little help for investors as the Securities and Exchange Commission has blessed the use of adjusted results as long as companies disclose how they are calculated. The disclosures are minimal, and are easy to get around when it comes to forecasts. Worse, adjusted earnings are used to determine executive bonuses and whether companies are meeting their loan covenants. No wonder CEO pay, and leverage, just goes up.

Conclusion & Why EBITDA Is BullS***

Wall Street is an insider system where legally manipulating earnings to create the best possible outcome, and increase executive compensation has run amok,. The adults in the room, a.k.a. the Securities & Exchange Commission, have “left the children in charge,” but will most assuredly leap into action to pass new regulations to rectify reckless misbehavior AFTER the next crash.

For fundamental investors, the manipulation of earnings not only skews valuation analysis, but specifically impacts any analysis involving earnings such as P/E’s, EV/EBITDA, PEG, etc.

Ramy Elitzur, via The Account Art Of War, expounded on the problems of using EBITDA.

“One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA, and that cash flow information is not as important. It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health.”

The article is worth reading and chocked full of good information, however, here are the four-crucial points:

  1. EBITDA is not a good surrogate for cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading to a false sense of liquidity.
  2. Superficial common garden-variety accounting ratios will fail to detect signs of liquidity problems.
  3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
  4. EBITDA, just like net income is very sensitive to accounting manipulations.

The last point is the most critical. As Charlie Munger recently stated:

“I think there are lots of troubles coming. There’s too much wretched excess.

I don’t like when investment bankers talk about EBITDA, which I call bulls— earnings.

It’s ridiculous. EBITDA does not accurately reflect how much money a company makes, unlike traditional earnings. Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”

In a world of adjusted earnings, where every company is way above average, every quarter, investors quickly lose sight of what matters most in investing.

“This unfortunate cycle will only be broken when the end-users of financial reporting — institutional investors, analysts, lenders, and the media — agree that we are on the verge of systemic failure in financial reporting. In the history of financial markets, such moments of mental clarity most often occur following the loss of vast sums of capital.” – American Accounting Association

Imaginary worlds are nice, it’s just impossible to live there.

Gimme Shelter – Unlocked RIA Pro

Oh, a storm is threat’ning my very life today
If I don’t get some shelter oh yeah I’m gonna fade away
” – Rolling Stones

The graph below plots 15 years’ worth of quarterly earnings per share for a large, well known publicly traded company. Within the graph’s time horizon is the 2008 financial crisis and recession. Can you spot where it occurred? Hint- it is not the big dip on the right side of the graph or the outsized increase in the middle.

The purpose of asking the question is to point out that this company has very steady earnings growth with few instances of marked variation. The recession of 2008 had no discernable effect on their earnings. It is not a stretch to say the company’s earnings are recession-proof.

The company was formed in 1886 and is the parent of an iconic name brand known around the world. The company has matured into a very predictable company, as defined by steady earnings growth.

Fundamentally, this company has all the trappings of a safe and conservative investment the likes of which are frequently classified as defensive value stocks. These kinds of companies traditionally provide a degree of safety to investors during market drawdowns. Today, however, this company and many other “shelter stocks” are trading at valuations that suggest otherwise.

The following article was posted for RIA Pro subscribers last week.

For more research like this as well as daily commentary, investment ideas, portfolios, scanning and analysis tools, and our new 401K manager sign up today at RIA Pro and test drive our site for 30 days before being charged.

What is Value?

Determining the intrinsic value for an investment is a crucial baseline metric that investors must calculate if they want to properly determine whether the share price of a company is rich, cheap, or fair.

Investors use a myriad of computations, forecasts, and assumptions to calculate intrinsic value. As such, the intrinsic value for a company can vary widely based on numerous factors. 

We broadly define intrinsic value as the price that a rational investor would pay for the discounted cash flows, after expenses, of a company. More simply, what is the future stream of net income worth to you? As value investors, we prefer to invest in companies where the market value is below the intrinsic value. Doing so provides a margin of safety.

Jim Rogers, the former partner of George Soros, put it this way: “If you buy value, you won’t lose much even if you’re wrong.”

Calculating the intrinsic value with a high level of confidence is difficult, if not impossible, for some companies. For instance, many smaller biotech companies are formed to find a cure or treatment for one or two medical ailments. These firms typically lose money and burn through funding during the research and development (R&D) stage. If they successfully find a treatment or cure and financially survive the long FDA approval process, the shareholders are likely to receive hefty returns. The outcome may also be positive if they have a promising medication and a suitor with deep pockets buys the company. Because the outcome is uncertain, many biotech companies fail to maintain enough funding through the R&D stage.

Calculating an intrinsic value for a small biotech company can be like trying to estimate what you may win or lose at a roulette table. The number of potential outcomes is immense and highly dependent on your assumptions. 

Coca-Cola

At the other end of the spectrum, there are mature companies with very predictable cash flows, making intrinsic value calculations somewhat simple, as we will show.

Coca Cola (KO) is the company we referenced in the opening section. KO is one of the most well-known companies in the world, with an array of products sold in almost every country. KO is mature in its lifecycle with very dependable sales and earnings growth. The question we raise in this analysis is not whether or not KO is a good company, but whether or not its stock is worth buying.  To answer this question, we will determine its intrinsic value and compare it to the current value of the company.

The textbook way to calculate intrinsic value is to discount the future cash flows of the company. The calculation entails projecting net income for the next 30 years, discounting those annual income figures at an appropriate rate, and summing up the discounted cash flows. The answer is the present value of the total earnings stream based on an assumed earnings growth rate.

In our intrinsic value model for KO, we assumed an earnings growth rate of 4.5%, derived from its 20 year annualized earnings growth rate of 5.4% and it’s more recent ten year annualized growth rate of 2.9%. Recent trends argue that using 5.4% is aggressive. We used a discounting factor of 7% representing the historical return on equities. The model discounted 30 years of estimated future earnings.

The model, with the assumptions above, yields an intrinsic value of $157 billion. The current market cap, or value, of KO is $235 billion, meaning the stock is about 51% overvalued. Even if we assume the longer-term 20-year growth rate (5.4%), the stock is still 35% overvalued.

To confirm the analysis and illustrate it in a different format, we calculated what the stock price would be on a rolling basis had it grown in line with the prior rate of ten years of earnings growth. As shown in the graph and table below, the market value is currently 55% above the model’s valuation for KO.  The green and red areas highlight how much the stock was overvalued and undervalued.

To check our analysis, we enlisted our friend David Robertson from Arete Asset Management and asked him what intrinsic value his cash flow based model assigned to KO. The following is from David:

In looking at the valuation of KO, I see a couple of familiar patterns. The most obvious one is that the warranted value, based on a long-term model that discounts expected cash flows, is substantially below the current market value. Specifically, the warranted value per share is about $21, and nowhere near the mid-50s current market price. The biggest reason for this is that the discounted value of future investments has declined the last few years substantially due to lower economic returns and lower sustainable growth rates. In other words, as the company’s ability to generate future returns has diminished, its stock price has completely failed to capture the change.

The chart below from David compares his model’s current and future intrinsic value (Arete target) with the annual high, low, and closing price for KO.  David’s graph is very similar to what we highlighted above; KO has been trading at a steep premium to its intrinsic value for the last few years.

Lastly, we share a few more facts about KO’s valuations.

  • Revenues (sales) have been in decline since 2012
  • Price to Sales (6.99) is at a 20 year high and three times greater than the faster growing S&P 500
  • Price to Earnings (25.83 –trailing 12 mos.) is at a 17 year high
  • Price to Book (11.24) is at an 18 year high
  • Enterprise Value to EBITDA is at an eight-year high
  • Capital Expenditures are at a 15 year low and have declined rapidly over the last eight years
  • Book Value is at a ten year low
  • Debt has tripled over the last ten years while revenues and earnings have grown at about 15-20% over the same period

When Value Becomes Growth

In 2018 we wrote a six-part RIA Pro series called Value Your Wealth. Part of the series was devoted to the current divergence between value and growth stocks and the potential for outsized returns for value investors when the market reverts to the mean. In the article, we explored mutual funds and S&P sectors to show how value can be defined, but also how the title “value” is being mischaracterized.

One of the key takeaway from the series is that finding value is not always as easy as buying an ETF or fund with the word “value” in it. Nor, as we show with KO, can you rely on traditional individual stock mainstays to provide true value. Today’s value hunters must work harder than in years past.

Based on our model, KO traded below the model’s intrinsic value from 2003 through 2013 and likely in the years prior. As noted, its average discount to intrinsic value during this period was 41%. Since 2014 KO has traded well above its intrinsic value.

In 2014 passive investing strategies started to gain popularity. As this occurred, many companies’ share prices rose faster than their earnings growth. These stocks became connected to popular indexes and disconnected from their fundamentals. The larger the company and the more indexes they are in, the more that the wave of passive investing helped the share price. KO meets all of those qualifications. As the old saying goes, if you buy enough of them, the price will go up.

Summary

Buying “Value” is not as easy as buying shares in well-known companies with great brand names, proven track records, and relative earnings stability. As we exemplified with KO, great companies do not necessarily make great investments.

The bull market starting in 2009 is unique in many aspects. One facet that we have written extensively on is how so many companies have become overpriced due to indiscriminate buying from passive investment strategies. This has big implications for the next equity market drawdown as companies like KO may go down every bit as much or even more than the broader market.

Be careful where you seek shelter in managing your portfolio of stocks; it may not be the safe bunker that you think it is.  

In a follow-up article for RIA Pro, we will present similar analysis and expose more “value” companies.

Gimme Shelter

Oh, a storm is threat’ning my very life today
If I don’t get some shelter oh yeah I’m gonna fade away
” – Rolling Stones

The graph below plots 15 years’ worth of quarterly earnings per share for a large, well known publicly traded company. Within the graph’s time horizon is the 2008 financial crisis and recession. Can you spot where it occurred? Hint- it is not the big dip on the right side of the graph or the outsized increase in the middle.

The purpose of asking the question is to point out that this company has very steady earnings growth with few instances of marked variation. The recession of 2008 had no discernable effect on their earnings. It is not a stretch to say the company’s earnings are recession-proof.

The company was formed in 1886 and is the parent of an iconic name brand known around the world. The company has matured into a very predictable company, as defined by steady earnings growth.

Fundamentally, this company has all the trappings of a safe and conservative investment the likes of which are frequently classified as defensive value stocks. These kinds of companies traditionally provide a degree of safety to investors during market drawdowns. Today, however, this company and many other “shelter stocks” are trading at valuations that suggest otherwise.

What is Value?

Determining the intrinsic value for an investment is a crucial baseline metric that investors must calculate if they want to properly determine whether the share price of a company is rich, cheap, or fair.

Investors use a myriad of computations, forecasts, and assumptions to calculate intrinsic value. As such, the intrinsic value for a company can vary widely based on numerous factors. 

We broadly define intrinsic value as the price that a rational investor would pay for the discounted cash flows, after expenses, of a company. More simply, what is the future stream of net income worth to you? As value investors, we prefer to invest in companies where the market value is below the intrinsic value. Doing so provides a margin of safety.

Jim Rogers, the former partner of George Soros, put it this way: “If you buy value, you won’t lose much even if you’re wrong.”

Calculating the intrinsic value with a high level of confidence is difficult, if not impossible, for some companies. For instance, many smaller biotech companies are formed to find a cure or treatment for one or two medical ailments. These firms typically lose money and burn through funding during the research and development (R&D) stage. If they successfully find a treatment or cure and financially survive the long FDA approval process, the shareholders are likely to receive hefty returns. The outcome may also be positive if they have a promising medication and a suitor with deep pockets buys the company. Because the outcome is uncertain, many biotech companies fail to maintain enough funding through the R&D stage.

Calculating an intrinsic value for a small biotech company can be like trying to estimate what you may win or lose at a roulette table. The number of potential outcomes is immense and highly dependent on your assumptions. 

At the other end of the spectrum, there are mature companies with very predictable cash flows, making intrinsic value calculations somewhat simple, as we will show.

Coca-Cola

Coca Cola (KO) is the company we referenced in the opening section. KO is one of the most well-known companies in the world, with an array of products sold in almost every country. KO is mature in its lifecycle with very dependable sales and earnings growth. The question we raise in this analysis is not whether or not KO is a good company, but whether or not its stock is worth buying.  To answer this question, we will determine its intrinsic value and compare it to the current value of the company.

The textbook way to calculate intrinsic value is to discount the future cash flows of the company. The calculation entails projecting net income for the next 30 years, discounting those annual income figures at an appropriate rate, and summing up the discounted cash flows. The answer is the present value of the total earnings stream based on an assumed earnings growth rate.

In our intrinsic value model for KO, we assumed an earnings growth rate of 4.5%, derived from its 20 year annualized earnings growth rate of 5.4% and it’s more recent ten year annualized growth rate of 2.9%. Recent trends argue that using 5.4% is aggressive. We used a discounting factor of 7% representing the historical return on equities. The model discounted 30 years of estimated future earnings.

The model, with the assumptions above, yields an intrinsic value of $157 billion. The current market cap, or value, of KO is $235 billion, meaning the stock is about 51% overvalued. Even if we assume the longer-term 20-year growth rate (5.4%), the stock is still 35% overvalued.

To confirm the analysis and illustrate it in a different format, we calculated what the stock price would be on a rolling basis had it grown in line with the prior rate of ten years of earnings growth. As shown in the graph and table below, the market value is currently 55% above the model’s valuation for KO.  The green and red areas highlight how much the stock was overvalued and undervalued.

To check our analysis, we enlisted our friend David Robertson from Arete Asset Management and asked him what intrinsic value his cash flow based model assigned to KO. The following is from David:

In looking at the valuation of KO, I see a couple of familiar patterns. The most obvious one is that the warranted value, based on a long-term model that discounts expected cash flows, is substantially below the current market value. Specifically, the warranted value per share is about $21, and nowhere near the mid-50s current market price. The biggest reason for this is that the discounted value of future investments has declined the last few years substantially due to lower economic returns and lower sustainable growth rates. In other words, as the company’s ability to generate future returns has diminished, its stock price has completely failed to capture the change.

The chart below from David compares his model’s current and future intrinsic value (Arete target) with the annual high, low, and closing price for KO.  David’s graph is very similar to what we highlighted above; KO has been trading at a steep premium to its intrinsic value for the last few years.

Lastly, we share a few more facts about KO’s valuations.

  • Revenues (sales) have been in decline since 2012
  • Price to Sales (6.99) is at a 20 year high and three times greater than the faster growing S&P 500
  • Price to Earnings (25.83 –trailing 12 mos.) is at a 17 year high
  • Price to Book (11.24) is at an 18 year high
  • Enterprise Value to EBITDA is at an eight-year high
  • Capital Expenditures are at a 15 year low and have declined rapidly over the last eight years
  • Book Value is at a ten year low
  • Debt has tripled over the last ten years while revenues and earnings have grown at about 15-20% over the same period

When Value Becomes Growth

In 2018 we wrote a six-part RIA Pro series called Value Your Wealth. Part of the series was devoted to the current divergence between value and growth stocks and the potential for outsized returns for value investors when the market reverts to the mean. In the article, we explored mutual funds and S&P sectors to show how value can be defined, but also how the title “value” is being mischaracterized.

One of the key takeaway from the series is that finding value is not always as easy as buying an ETF or fund with the word “value” in it. Nor, as we show with KO, can you rely on traditional individual stock mainstays to provide true value. Today’s value hunters must work harder than in years past.

Based on our model, KO traded below the model’s intrinsic value from 2003 through 2013 and likely in the years prior. As noted, its average discount to intrinsic value during this period was 41%. Since 2014 KO has traded well above its intrinsic value.

In 2014 passive investing strategies started to gain popularity. As this occurred, many companies’ share prices rose faster than their earnings growth. These stocks became connected to popular indexes and disconnected from their fundamentals. The larger the company and the more indexes they are in, the more that the wave of passive investing helped the share price. KO meets all of those qualifications. As the old saying goes, if you buy enough of them, the price will go up.

Summary

Buying “Value” is not as easy as buying shares in well-known companies with great brand names, proven track records, and relative earnings stability. As we exemplified with KO, great companies do not necessarily make great investments.

The bull market starting in 2009 is unique in many aspects. One facet that we have written extensively on is how so many companies have become overpriced due to indiscriminate buying from passive investment strategies. This has big implications for the next equity market drawdown as companies like KO may go down every bit as much or even more than the broader market.

Be careful where you seek shelter in managing your portfolio of stocks; it may not be the safe bunker that you think it is.  

In a follow-up article for RIA Pro, we will present similar analysis and expose more “value” companies.

Investing Versus Speculating

Value investing is an active management strategy that considers company fundamentals and the valuation of securities to acquire that which is undervalued. The time-proven investment style is most clearly defined by Ben Graham and David Dodd in their book, Security Analysis. In the book they state, “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

There are countless articles and textbooks written about, and accolades showered upon, the Mount Rushmore of value investors (Graham, Dodd, Berkowitz, Klarman, Buffett, et al.). Yet, present-day “investors” have shifted away from the value proposition these greats profess as the time-tested secret to successful investing and compounding wealth.  

The graph below shows running ten year return differentials between value and growth. Clearly, as shown, investors are chasing growth at the expense of value in a manner that is quite frankly unprecedented over the last 90 years.

Data Courtesy French, Fama, and Dartmouth

In the 83 ten year periods starting in 1936, growth outperformed value only eight times. Five of those ten year periods ended in each of the last five years.

Contrast

Value stocks naturally trade at a discount to the market. Companies with weaker than market fundamental growth leads to discounted valuations and a perception among investors that is too pessimistic about their ability to eventually achieve a stronger growth trajectory.

Growth stocks are those that pay little or no dividends but promise exceptional revenue and earnings growth in the future.

The outperformance of growth over value stocks is natural in times when investors become exuberant. Modern-day market participants claim superior insight into this Fed-controlled, growth-friendly environment. Based on the media, it appears as if the business cycle is dead, and recessions are an archaic thing of the past. Growth stocks promising terrific streams of cash flow at some point in the future rule the day. This naturally leads to investors becoming too optimistic and extrapolate strong growth far into the future.

Meanwhile, value companies tend to retain an advantage by offering higher market yields than growth stocks. That edge may only be 1 or 2% but compounded over time, it is significant. The problem is that when valuations on the broad market become elevated, as they are now, that premium compresses and diminishes the income effect. The problem is temporary, however, assuming valuations eventually mean-revert.

One other important distinction of value companies is that they, more commonly than growth companies, end up as takeover targets. Historically, this has served as another premium in favor of value investing. Over the course of the past 12 years, however, corporate capital has uncharacteristically been more focused on growth companies and the ability to tell their shareholder a tale of wild earnings growth that accompany their takeover targets. This is likely due to the environment of ultra-low interest rates, highly accommodative debt markets, and investors that are not focused on the inevitability of the current business cycle coming to an end.

Active versus Passive

Another related facet to the value versus growth discussion is active versus passive investment management. Although active management may be involved in either category, value investing, as mentioned above, must be an active strategy. Managers involved in active management require higher fees for those efforts. Yet, as value strategies have underperformed growth for the past 12 years, many investors are questioning the active management logic.

Why pay the high fees of active managers when passive management suffices at a cost of pennies on the dollar? But as Graham and Dodd defined it, passive strategies are not investing, they are speculating. As the graph below illustrates, the shift out of active management and into passive funds is stark.

Overlooking the historical benefits and outperformance of value managers, current investors seek to chase returns at the lowest cost. This behavior is reflective of a troubling lack of discipline and suggests that investors are complacent about the possibility of having their equity wealth cut in half as it was in two episodes since 2000.

Pure passive investing, investing in a mutual fund or exchange-traded fund (ETF) that mimics an index, represents a low-fee approach to speculation. It does not involve “thorough analysis,” the promise of “safety of principal,” or an “adequate return.” Capital received is immediately deployed and invested dollars are weighted most heavily toward the most expensive stocks. This approach represents the opposite of the “buy-low, sell-high” golden rule of investing.

Active management, on the other hand, involves analytical rigor by usually seasoned managers and investors seeking out opportunities in good companies in which to invest at the best price.

Definition of Terms

To properly emphasize the worth of value investing, it is important first to define a couple of key terms that many investors tend to take for granted.

Risk – Contrary to Wall Street marketing propaganda, risk is not a number calculated by a formula in a spreadsheet. Risk is simply the likelihood of a substantial and permanent loss of capital with no ability to ever recover. Exposure to risk cannot be mitigated by blind diversification. Real risk cannot be quantified by processing the standard deviation of historical returns or the sophisticated variations of Value-at-Risk. These calculations and the many assumptions within them lead to misperceptions and misplaced confidence.

Wealth – Wealth is savings. It is that which is left over after consumption and is the accumulation of savings over time. Wealth results from the compounding of earnings. Wealth is not the net value of assets minus liabilities. That is a balance sheet metric that can change dramatically and suddenly depending on economic circumstances. An investor who seeks to sell high and buy low, like a business owner who prudently waits for opportunities to buy out competitors when they are distressed, uniquely illustrates proper wealth management and are but two forms of value investors.

Economic Worldview

Understanding these terms is important because it affects one’s economic worldview and the ability to make prudent investment decisions consistently. As Dylan Grice of Edelweiss Holdings describes it:

Language is the machinery with which we conceptualize the world around us. Devaluing language is tantamount to devaluing our ability to think and understand.” Grice continues, clarifying that point, “linguistic precision leads to cognitive precision.”

Value investors understand that compounding wealth depends on avoiding large losses. These terms and their proper definitions serve as a rock-solid foundation for sound reasoning and analytical rigor of market forces, central bank policies, and geopolitical dynamics that influence global liquidity, asset prices, and valuations. They enable critical foresight.

Proper definitional terms clarify the logical framework for an investor to benchmark their wealth, net of inflation, rather than obsessing with benchmarking returns to those of the S&P 500 or other passive indexes. Redefining one’s benchmark to inflation plus some excess return properly aligns target returns with life goals. Comparisons to the returns of the stock market are irrelevant to your goals and induce one to be dangerously urgent and speculative.

Value investing is having the courage to be opportunistic when others are pessimistic, to buy what others are selling, and to embrace volatility because it is in those times of upheaval that the greatest opportunities arise. That courage is derived from clarity of goals and a sturdy premise of assessing value. This is not an easy task in a world where the discounting mechanism itself has become so disfigured as to be rendered little more than a reckless guess.  

Properly executed, value investing seeks to find opportunities to deploy capital in such a way that reduces risk by acquiring assets at prices that are sufficiently below intrinsic value. This approach also extends to potential gains and creates a desirable performance asymmetry.

In the words of famed investor and former George Soros colleague, Jim Rogers, “If you buy value, you won’t lose much even if you’re wrong.” And let’s face it, everybody in this business is wrong far more than they’re right.

Summary

Analytically, safety, and profits are rooted in buying assets with abnormally large risk premiums and then having the patience to wait for mean reversion. It often requires the rather unconventional approach of identifying those areas where there is distress and misguided selling is occurring.

As briefly referenced above in the definition of wealth, a value investor manages money as a capitalist business owner would manage his company. A value investor is more interested in long-term survival. Their decisions are motivated by investing in companies that are doing those things that will add to the substance and durability of the enterprise. They are interested in companies that aim to enhance the cash flow of the operation and, ideally, do so with a very long time-preference and as a habitual pattern of behavior.

Unlike a business owner and an “investor,” most people who buy stocks think in terms of acquiring financial securities in hopes of selling them at a higher price. As a result, they make decisions primarily with a concern about what other investors’ expectations may be since that will determine tomorrow’s price. This is otherwise known as speculation, not investing, as properly defined by Graham and Dodd.

Although value investing strategies have underperformed relative to growth strategies for the past decade, the extent to which value has become cheap is reaching its limit.

We leave you with a question to ponder; why do you think Warren Buffet’s Berkshire Hathaway is sitting on $128 billion in cash?

Value Your Wealth – Part Six: Fundamental Factors

In this final article of our Value Your Wealth Series we explore four more fundamental factors. The first four articles in the Series researched what are deemed to be the two most important fundamental factors governing relative stock performance – the trade-off between growth and value. In Part Five, we explored how returns fared over time based on companies market cap. Thus far, we have learned that leaning towards value over growth and smaller market caps is historically an investment style that generates positive alpha. However, there are periods such as now, when these trends fail investors.

The last ten years has generally bucked long-standing trends in many factor/return relationships. This doesn’t mean these factors will not provide an edge in the future, but it does mean we need to adapt to what the market is telling us today and prepare for the day when the historical trend reverts to normal.  When they do, there will likely be abundant opportunities for investors to capture significant alpha.

The five prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Part Five: Market Cap

Four Factors

In this section, we explore four well-followed factors to understand how they performed in the past and how we might want to use them within our investment decision-making process.

The graphs in this article are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

Earnings to Price

Investors betting on companies with a higher ratio of Earnings to Price (E/P), also known as the earnings yield, have historically outperformed investors betting on companies with lower E/P ratios. Such outperformance of companies priced at relatively cheap valuations should be expected over time.

The following chart compares monthly, ten year annually compounded returns for the highest and lowest E/P deciles. 

The graph of E/P is very similar to what we showed for growth versus value. Other than a period in the 1990s and the current period value outperformed growth and the top E/P companies outperformed the bottom ones. This correlation is not surprising as E/P is a key component that help define value and growth.

Investors buying the top ten percent of the cheapest companies, using E/P, have been docked almost 5% annually or about 50% since the recovery following the financial crisis versus those buying the lowest ten percent of companies using this measure.

Given our fundamental faith in mean reversion, we have no doubt this trend will begin to normalize in due time. To help us gauge the potential return differential of an E/P reversion, we calculate future returns based on what would happen if the ten-year return went back to its average in three years. This is what occurred after the tech bust in 2000. In other words, if the ten year annualized compounded return in late 2022 is average (4.81%) what must the relative outperformance of high E/P to low E/P companies be over the next three years? If this occurs by 2022, investors will earn an annual outperformance premium of 28.1% for each of the next three years. The returns increase if the time to reversion is shorter and declines if longer. If normalization occurs in five years the annual returns drop to (only) 14.75%.

Needless to say, picking out fundamentally solid stocks seems like a no-brainer at this point but there is no saying how much longer speculation will rule over value.

Cash Flow to Price

The graph below charts the top ten percent of companies with the largest ratio of cash flow to price and compares it to the lowest ones. Like E/P, cash flow to price is also a component in value and growth analysis.

Not surprisingly, this graph looks a lot like the E/P and value vs. growth graphs. Again, investors have shunned value stocks in favor of speculative entities meaning they are neglecting high quality companies that pay a healthy dividend and instead chasing the high-flying, over-priced “Hollywood” stocks. Also similar to our potential return analysis with E/P, those electing to receive the most cash flows per dollar of share price will be paid handsomely when this factor reverts to normal.

Dividend Yield

Over the last 100 years, using dividend yields to help gain alpha has not been as helpful as value versus growth, market cap, earnings, and cash flows as the chart below shows.

On average, higher dividend stocks have paid a slight premium versus the lowest dividend stocks.While dividend yields are considered a fundamental factor it is also subject to the level of interest rates and competing yields on corporate bonds.If we expect Treasury yield levels to be low in the future then the case for high dividend stocks may be good as investors look for alternative yield as income. The caveat is that if rates decline or even go negative, the dividend yield may be too low to meet investors’ bogeys and they may chase lower dividend stocks that have offered higher price returns.

Momentum

Momentum, in this analysis, is calculated by ranking total returns from the prior ten months for each company and then sorting them. Before we created the graph below, we assumed that favoring momentum stocks would be a dependable investment strategy. Our assumption was correct as judged by the average 10.89% annual outperformance. However, we also would have guessed that the last few years would have been good for such a momentum strategy.

Quite to the contrary, momentum has underperformed since 2009. The last time momentum underperformed, albeit to a much a larger degree, was the Great Depression.

Our initial expectation was based on the significant rise of passive investing which favors those companies exhibiting strong momentum. As share prices rise relative to the average share price, the market cap also rises versus the average share and becomes a bigger part of indexes.  If we took the top 1 or 2% of companies using momentum we think the strategy would have greatly outperformed the lower momentum companies, but when the top and bottom ten percent are included momentum has not recently been a good strategy.

Summary

Factors give investors an informational edge. However, despite long term trends that offer favorable guidance, there are no sure things in investing. The most durable factors that have supplied decades of cycle guidance go through extended periods of unreliability. The reasons for this vary but certainly a speculative environment encouraged by ultra-low and negative interest rates has influence. Investors must recognize when they are in such periods and account for it. More importantly, though, they must also understand that when the trends are inclined to reverse back to normal. The potential for outsized relative gains at such times are large.

At RIA Advisors, Factor analysis is just one of many tools we use to help us manage our portfolios and select investments. We are currently leaning towards value over growth with the belief that the next market correction will see a revival of the value growth trends of the past. That said, we are not jumping into the trade as we also understand that growth may continue to beat value for months or even years to come.

Patience, discipline, and awareness are essential to good investing. 

Value Your Wealth – Part Five: Market Cap

The first four articles in this series focused on what might be the most important pair of fundamental factors – growth and value. Those factors have provided investors long-standing, dependable above-market returns.  Now, we take the series in a different direction and focus on other factors that may also give us a leg up on the market. 

The term “a leg up” is important to clarify. In general, factor-based investing is used to gain positive alpha or performance that is relatively better than the market. While “better” than market returns are nice, investing based on factor analysis should not be the only protection you have when you fear that markets may decline sharply. The combination of factor investing and adjustments to your total equity exposure is a time-trusted recipe to avoid large drawdowns that impair your ability to compound wealth.

We continue this series with a discussion of market capitalization.

The four prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Market Cap

Market capitalization, commonly known as market cap, is a simple calculation that returns the current value or size of publicly traded companies. The formula is the number of shares outstanding times the price per share. For example as we wrote this article, Apple has 4.601 billion shares outstanding and Apple’s stock trades at roughly $210 per share. Apple’s market cap is $966.21 billion. 

Most investors, along with those in the financial media, tend to distinguish companies market caps/size by grouping them into three broad tiers – small-cap, mid-cap, and large-cap. Over most periods, stocks in the three categories are well correlated. However, there are periods when they diverge, and we are currently amidst such a deviation. Since September 1, 2018, the price of the Large Cap S&P 500 Index has risen by 4.1%, while the price of the Small Cap S&P 600 Index is down 12.9%.  Deviations in historical relationships, whether short or long-term in nature, can provide investors an opportunity to capitalize on the normalization of the relationship, but timing is everything. 

Historical Relative Performance

The following graphs are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

The data set provides returns based on market cap groupings based on deciles. The first graph compares annualized total return and annualized volatility since 1926 of the top three (High) and bottom three (Low) market cap deciles as well as the average of those six deciles. To be clear, a decile is a discrete range of market caps reflecting the stocks in that group. For example, in a portfolio of 100 stocks, decile 1 is the bottom ten stocks, or the smallest ten market cap stocks, decile two is the next ten smallest cap stocks, etc.

The next graph below uses monthly ten year rolling returns to compare total returns of the highest and lowest deciles. This graph is a barometer of the premium that small-cap investing typically delivers to long term investors.

The takeaway from both graphs is that small-cap stocks tend to outperform large-cap stocks more often than not. However, the historical premium does not come without a price. As shown in the first graph, volatility for the lowest size stocks is almost twice that of the largest. If you have a long time horizon and are able and willing to stay invested through volatile periods, small caps should fare better than large caps. 

Small-cap stocks, in general, have high expected growth rates because they are not limited by the constraints that hamper growth at larger companies. Unfortunately, small-cap earnings are more vulnerable to changes in industry trends, consumer preferences, economic conditions, market conditions, and other factors that larger companies are better equipped and diversified to manage. 

Periods of Divergence

The second graph above shows there are only three periods where large caps outperformed small caps stocks since 1926. Those three exceptions, the 1950’s, 1990’s and, the post-financial crisis-era are worth considering in depth.

The 1950s The Nifty Fifty- The end of World War II coupled with a decade of historically low interest rates disproportionately helped larger companies. These firms, many global, benefited most from the efforts to rebuild Europe and partake in the mass suburbanization of America.

The 1990s Tech Boom- With double-digit inflation a distant memory and the swelling technology boom, larger companies that typically benefited most from lower rates, less inflation, and new technologies prospered. While this new technology benefited all companies in one form or another, larger ones had the investment budgets and borrowing capacity to leverage the movement and profit most. 

The 2010’s Post Financial Crisis Era –The current period of large-cap outperformance is unique as economic growth has been prolonged but below average and productivity growth has been negligible. Despite relatively weak economic factors, massive amounts of monetary stimulus has fueled record low corporate borrowing rates, which in turn have fueled stock buybacks. Further, the mass adaptation of passive cap-weighted investment strategies naturally favors companies with large market caps. Circularly, passive investing feeds on itself as indexed ETFs and mutual funds must increasingly allocate more to large caps which grow in size relative to the other holdings.

To reiterate an important point: the current period of outperformance is not based on solid economic fundamentals and resulting corporate earnings growth as in the two prior periods described. This episode is a byproduct of monetary actions.

The graph below highlights the distinction between the current period and the two prior periods where large caps outperformed.  

Summary

Historically, small-cap stocks tend to provide a return premium over large-cap stocks. However, as we pointed out, there are periods where that is not the case. Currently, large-cap stocks are the beneficiaries of overly generous monetary and fiscal policy. We do believe the relationship will return to normal, but that will likely not occur until a bear market begins.

As we wait for a normalization of valuations and traditional relationships that have become so disfigured in this cycle, we consider the current relative valuations on small-cap stocks similar to those we described in value stocks earlier in this series. The time to weight your stock portfolio allocation more heavily toward small-cap opportunities is coming, but every investor must decide on their own or with good counsel from an advisor when to make that adjustment.  When appropriate, a gradual shift to small-cap stocks from large caps depends on an investor’s risk appetite and defensive preference.

More importantly, have a plan in place because when the market does meaningfully correct, the premium small-cap stocks provide will likely help cushion against a stock market correction. 

Value Your Wealth – Part Four: Mutual Fund & ETF Analysis

Parts One through Three of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

In Part One, the introduction to our Value Your Wealth series, we documented how recent returns for investors focused on growth companies have defied the history books and dwarfed returns of investors focused on value stocks. In particular: “There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.”

In this, the fourth part of the Value Your Wealth series, we focus on growth and value mutual funds and ETFs. Our purpose is to help determine which professional value and growth fund managers are staying true to their stated objectives.

Fund Analysis

A large part of most investor’s investment process starts with the determination of an investment objective. From this starting point, investors can appropriately determine the asset classes and investment strategies that will help them achieve or even exceed their objectives. 

Once an investor decides upon an objective, strategy, and asset class, they must select individual securities or funds. This article focuses singularly on assessing growth and value mutual funds and ETFs. In particular it shows how an investor focused on growth or value can choose funds that are managed properly to meet their goals.

Investors usually key on the following factors when selecting a mutual fund or ETF: 

  • Declared fund strategy (Growth or Value in this case)
  • Prior period returns
  • Fee and expense structure
  • Reputation of the fund family and possibly the manager

These four factors provide valuable information but can be misleading.

For instance, prior returns provide a nice scorecard for the past but can be deceptive. As an example, if we are currently scanning for value funds based on performance, the highest ranking funds will more than likely be those that have leaned most aggressively toward growth stocks. While these funds may seem better, what we believe is more important the fund managers adherence to their objectives.  Given we are looking forward and believe value will outperform growth, we want fund managers that we can trust will stick with value stocks.

It is also important not to shun funds with the highest expenses and/or gravitate towards those with the lowest. We must be willing to pay up, if necessary, to achieve our objectives. For instance, if a fund offers more exposure to value stocks than other comparable value funds, it may be worth the higher fee for said exposure. Conversely, there are many examples where one can gain more exposure to their preferred strategy with cheaper funds. 

Most investors check the fund strategy, but they fail to determine that a fund is being effectively and cost efficiently managed towards their stated strategy. 

We now compare the largest growth and value mutual funds and ETFs to assess which funds offer the most value, so to speak. 

Mutual Fund/ETF Analysis

In order to limit the population of value and growth mutual funds and ETFs to a manageable number, we limited our search to the largest funds within each strategy that had at least 85% exposure to U.S. based companies. We further restricted the population to those funds with a stated strategy of growth or value per Bloomberg.

In prior articles of this series, we have used Bloomberg growth and value factor scores and our own growth and value composite scores. While we would prefer to use our own computations, the large and diverse holdings of the mutual funds and ETFs make it nearly impossible for this exercise. Accordingly, Bloomberg growth and value factor scores provide us the most accurate description of where the respective funds lie on the growth/value spectrum. It is important to note that Bloomberg assigns every fund both a growth and a value score. We consider both scores and not just the score pertinent to growth or value.

We understand most of our readers do not have access to Bloomberg data. As such, we provide a DIY approach for investors to track growth and value exposure amongst mutual funds and ETFs.

Growth and Value Scores

The scatter plot below shows the 54 funds analyzed. Each dot represents a fund and the intersection of its respective growth (x-axis) and value scores (y-axis). The funds most heavily skewed towards value (high value scores and low growth scores) are in the upper left, while heavily growth oriented funds are in the bottom right (high growth score and low value scores).  Information about the funds used in this report and their scores can be found in the tables below the graph. Certain funds are labeled for further discussion.   

A few takeaways:

  • VIVAX (Growth -.60, Value +.37): While this value fund is farthest to the left, there are other funds that offer more value exposure. However, this fund has the lowest growth score among value funds.
  • DFLVX (Growth -.43, Value +.68): This value fund offers an interesting trade off to VIVAX sporting a higher value score but a less negative growth score.
  • AIVSX (Growth +.10, Value -.05): Despite its classification as a value fund, AIVSX has a slight bias towards growth. Not surprisingly, this fund has recently outperformed other value funds but would likely underperform in the event value takes the lead.
  • FDGRX (Growth +.88, Value -.64): This growth fund offers both the highest growth score and lowest value score. For investors looking for an aggressive profile with strong growth exposure and little value exposure, this fund is worth considering.
  • VPMCX (Growth -.04, Value +.16): Despite its classification as a growth fund, VPMCX has a slight bias towards value.
  • In our opinion, the six funds with growth and value scores near zero (+/-.20) in the red box do not currently have a significant growth or strategy orientation, and as such, they are similar to a broad market index like the S&P 500.

It is important to stress that the data represents a snapshot of the fund portfolios for one day. The portfolio managers are always shifting portfolios toward a value or growth bias based on their market views.

 (CLICK on the tables to enlarge)

Data Courtesy Bloomberg

The data above gives us potential funds to meet our strategic needs. However, we also need to consider fees.  

Fees

The scatter plots below isolate growth and value funds based on their respective growth or value score and fees charged.

We circled three groupings of the growth funds to help point out the interaction of fees and growth scores. The four funds in the blue circle have average or above average fees versus other growth funds yet provide a minimal bias towards growth. The yellow circle represents a sweet spot between low fees and a good exposure to growth stocks. Lastly, the red circle shows funds where  heavy exposure to growth comes with above average fees.

This graph circles three groupings of value funds to help point out the interaction of fees and growth scores. The blue circle contains funds with little to no bias towards value. The yellow circle represents a good mix of value and cheap fees. The red circle, our sweet spot in this graph, shows that heavy exposure to value can be had with fees near the group average.

Alpha and Bad Incentives 

Alpha is a measure that calculates how much a portfolio manager, trader, or strategy over or underperforms an index or benchmark. From a career perspective, alpha is what separates good fund managers from average or bad ones.

We mention alpha as we believe the current prolonged outperformance of growth over value is pushing professional fund managers to stray from their stated objectives. As an example, a value based fund manager can add exposure to growth stocks to help beat the value index he or she is measured against.

Adding growth to a value fund may have proven to be alpha positive in the past, but we must concern ourselves with how well the fund manager is adhering to the fund’s objective Simply put, we are trying to find managers that are staying true to their objectives not those who have benefited from a deviation from stated strategy in the past.

It is important to note that positive alpha can be attained by sticking to the stated objective and finding stocks that outperform the index. This is the type of alpha that we seek.

DIY

As discussed, growth and value factors can change for funds based on the whims of the portfolio manager. Therefore, the data provided in this article will not age well. If you do not have access to Bloomberg to track value and growth scores we offer another approach.

Morningstar provides a blunt but effective style analysis tool.  To access it, go to www.morningstar.com and select your favorite fund. Then click on the tab labeled Portfolio and scroll down to Style Details.

The following screen print shows Morningstar’s style analysis for value fund DFLVX.

The box in the top right separates the fund’s holdings by market capitalization and value growth classifications. We can use this data to come up with our own scores. For instance, 59% (46+13) of DFLVX is biased toward value (red circle) while only 6% (5+1) is in growth companies (blue circle). To further demonstrate how a fund compares to its peers, the Value & Growth Measures table on the bottom left, compares key fundamental statistics. As shown by three of the first four valuation ratios, DFLVX has more value stocks than the average for funds with similar objectives.

Summary

The word “Value” in a fund name does not mean the fund takes on a value bias at all times. As investors, we must not rely on naming conventions. This means investors must do some extra homework and seek the funds that are truly investing in a manner consistent with the funds, and ultimately the investor’s, objective.

As we have mentioned, we are at a point in the economic and market cycles where investors should consider slowly rotating towards value stocks. Not only is the style historically out of favor, many of the names within that style are unjustifiably beaten down and due for mean reversion to more favorable levels. We hope this article provides some guidance to ensure that those who heed our advice are actually adding value exposure and not value in name only.

Value Your Wealth – Part Three: Sector Analysis

When we embarked on our Value Your Wealth series, we decided to present it using a top-down approach. In Parts One and Two, we started with basic definitions and broad analysis to help readers better define growth and value investment styles from a fundamental and performance perspective. With this basic but essential knowledge, we now drill down and present investment opportunities based on the two styles of investing.

This article focuses on where the eleven S&P sectors sit on the growth-value spectrum. For those that invest at a sector level, this article provides insight that allows you to gauge your exposure to growth and value better. For those that look at more specialized funds or individual stocks, this research provides a foundation to take that analysis to the next level.

Parts One and Two of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Sector Analysis

The 505 companies in the S&P 500 are classified into eleven sectors or industry types. While very broad, they help categorize the S&P companies by their main source of revenue. Because there are only eleven sectors used to define thousands of business lines, we must be acutely aware that many S&P 500 companies can easily be classified into several different sectors.

Costco (COST), for instance, is defined by S&P as a consumer staple. While they sell necessities like typical consumer staples companies, they also sell pharmaceuticals (health care), clothes, TVs and cars (discretionary), gasoline (energy), computers (information technology), and they own much of the property (real-estate) upon which their stores sit.

Additionally, there is no such thing as a pure growth or value sector. The sectors are comprised of many individual companies, some of which tend to be more representative of value and others growth.

As we discussed in Part Two, we created a composite growth/value score for each S&P 500 company based on their respective z-scores for six fundamental factors (Price to Sales, Price to Book, Price to Cash Flow, Price to Earnings, Dividend Yield, and Earnings Per Share). We then ranked the composite scores to allow for comparison among companies and to identify each company’s position on the S&P 500 growth-value spectrum. The higher the composite score, the more a company is growth oriented and the more negative the score, the more value-oriented they are.  

The table below summarizes the composite z-scores by sector.  To calculate this, we grouped each company based on its sector classification and weighted each company’s z-score by its market cap. Given that most indexes and ETFs/Mutual funds are market cap weighted, we believe this is the best way to arrange the sector index scores on the growth-value spectrum. 

Data courtesy Bloomberg

As shown, the Financial, Energy, and Utility sectors are the three most heavily weighted towards value.  Real-estate, Information Technology, and Consumer Discretionary represent the highest weighted growth sectors.

While it might be tempting to select sectors based on your growth-value preferences solely using the data in the table, there lies a risk. Some sectors have a large cross-section of both growth and value companies.  Therefore they may not provide you the growth or value that you think you are buying. As an example, we explore the communications sector.

The communications sector (represented by the ETF XLC) is a stark combination of old and new economy stocks. The old economy stocks are traditional media companies such as Verizon, Fox, CBS and News Corp. New economy stocks that depend on newer, cutting edge technologies include companies like Google, Facebook, Twitter, and Trip Advisor. 

As one might expect, the older media companies with more reliable earnings and cash flows are priced at lower valuations and tend to be defined as value stocks by our analysis. Conversely, the new economy companies have much higher valuations, are short on earnings, but come with the prospect of much higher growth potential.

The scatter plot below offers an illustration of the differences between growth, value and market capitalization within the communications sector. Each dot represents the intersection of market capitalization and the composite z-score for each company. The table below the scatter plot provides fundamental and performance data on the top three value and growth companies.

Data courtesy Bloomberg

As shown in the graph, the weighted average z-score (the orange circle) for the communications sector leans towards growth at +0.19. Despite the growth orientation, we deem 58% of the companies in the communications sector as value companies.

The following table compares the weighted average z-score for each S&P sector along with the variance of the underlying companies within the sector and the percentage of companies that are considered value and growth. We use standard deviation on the associated composite z-scores to determine whether companies are close together or far apart on the growth/value spectrum.  The lower the standard deviation, the more similar the companies are in terms of growth or value

Data courtesy Bloomberg

Again here, weightings, market capitalization, and the influence of individual stocks within a sector are important to understand The industrial sector, as shown above, has a score of +0.232, which puts it firmly in growth territory. However, Boeing (BA), due to its large market cap and significant individual growth score skews this sector immensely. Excluding BA, the weighted average composite score of the industrial sector registers as a value sector at -0.07. Again this highlights the importance of understanding where the growth and or value in any particular sector comes from.

Takeaways

The graph below shows the clear outperformance of the three most heavily growth-oriented sectors versus the three most heavily value-oriented. Since the beginning of the post-financial crisis, the three growth companies grew by an average of 480%, almost three times the 166% average of the three value companies.

This analysis provides you a basis to consider your portfolio in a new light. If you think the market has a few more innings left in the current expansion cycle, odds continue to favor a growth-oriented strategy. If you think the economy is late-cycle and the market is topping, shifting towards value may provide much-needed protection.  

While we believe the economic and market cycles are late stage, they have not ended. We have yet to receive a clear signal that value will outperform growth going forward. At RIA Advisors, growth versus value is a daily conversation, whether applied to sector ETF’s, mutual funds or individual stocks.  While we know it’s early, we also know that history has been generous to holders of value, especially after the rare instances when growth outperformed it over a ten-year period as it has recently.

Value Your Wealth – Part Two: Quantifying the Value Proposition

This article is the second in a series focused on growth versus value investment styles and its significance to managing your wealth in the current environment. If you have not read Part One, we urge you to read it first as it provides a foundation upon which this article builds. If you already read Part One, it may be helpful to go back and review the fundamental definitions of growth and value.

Human behavior has demonstrated the willingness of investors to get caught up in the euphoria of financial bubbles. The history books are chock full of tales about investors chasing the prices of tulips, technology stocks, and real estate to stratospheric levels. The collective enthusiasm of such periods has a hypnotic way of lulling even the most astute investors into the belief that stocks have reached “a permanently high plateau” (prominent economist Irving Fisher, 1929).

Like seasons and tides, however, markets and human behavioral patterns are cyclical. Mean reversion, like change, is one thing we can all count on. As the analysis below will illustrate, we appear to be in another one of those euphoric periods.

In time, euphoria will turn to despair. It is with this knowledge that we continue to expose the current paradigm between growth and value stocks so that you can prepare for this inevitability. Those who seek to compound wealth are well-served to understand the current circumstances and the nature of the contrast between the two investment approaches.

Currently, the differences in their valuations and performance are extreme in both magnitude and duration. If we are to believe that the realities of the world in which we live have been permanently suspended and there will be no mean reversion, then we should proceed to do what we did yesterday. If we believe that this cycle too will end, then we need to understand what is at risk and strategize on how to protect ourselves.

The data which follows puts a much finer point on the extremes we are currently observing and therefore the risks we assume by failing to acknowledge them.

What Constitutes Growth and Value

After coming across compelling work articulated on Bloomberg by Nir Kaisser, we decided to look deeper into the contrast between growth and value stocks. In taking on this project, we had two problems. The first problem was deciding how to quantitatively define growth and value. The second problem was retrieving and processing the data required to fairly analyze these two broad categories.

To keep this analysis both simple and applicable, we chose to limit our analysis to the constituents of the S&P 500. We also decided to use the six fundamentals listed below to quantitatively define and screen between value and growth.

  • Price-to-Sales (P/S)
  • Price-to-Book (P/B)
  • Price-to-Cash Flow (P/CF)
  • Price-to-Earnings (P/E)
  • Dividend Yield (DY)
  • Earnings per Share (Trailing 12-Months) (EPS)

Growth companies tend to have higher price-to-sales, price-to-book, price-to-cash flow and earnings per share and lower (often zero) dividend yield. Value companies are the opposite.

Keep in mind, the S&P 500 accounts for roughly 80% of U.S. stock market capitalization and within that index, 100 of the largest companies in the United States reside firmly in either the growth or value category. They are the top 50 in growth and the top 50 in value (by our definition) selected based on the fundamentals as described above.

Growth vs. Value Analysis

Identifying companies within the S&P 500 that properly fit into either the growth or value category was done by evaluating the valuation metrics referenced above, ranking companies based on a standard deviation (z-score) for each metric, and then aggregating data to compute a composite z-score.

The z-score, which tells us how many standard deviations from the mean a specific number is, can be calculated by taking the company-specific reading in one category, subtracting it from the average for the S&P 500, and then dividing that number by the standard deviation for the total S&P 500. One standard deviation includes approximately 68% of the data.  To clarify, we provide the example below.

  • The price-to-sales (P/S) for Boston Scientific (BSX) is 4.94
  • The average P/S for the S&P 500 is 3.60
  • The standard deviation for P/S for the S&P 500 is 3.25 (~68% of the data has a P/S of 3.60 +/-3.25)
  • Therefore, BSX has a P/S z-score of 0.413 calculated as (4.94-3.60)/3.25
  • This tells us that BSX’s P/S is 0.413 standard deviations above the average (conversely, if the z-score had been -0.413 then BSX P/S would have been 0.413 below the average)
  • Based solely on its positive P/S z-score and above average P/S ratio, BSX can be defined as a growth company.

We performed the same analysis for each S&P 500 company and each of the six fundamental metrics listed above.  We then created a composite based on the six z-scores for each company and ranked them.

Of the 500 companies in the S&P 500, we selected the 50 companies with the highest z-score composite, those clearly demonstrating the characteristics of a growth company, and the 50 lowest z-score composites, which are companies that fit the characteristics of a value company.

Using the results of the z-score analysis, we also looked at the total rate of return over various time frames for those stocks in our growth and value identified sectors. Return figures are inclusive of dividends.

Results – Fundamentals

The data below shows the sharp contrast between the average metrics for the 50 growth stocks and the 50 value stocks.

Data courtesy Bloomberg

The next table contrasts this data in a z-score format for each metric. The z-score analysis provides the ability to compare the two styles and understand how the growth and value companies compare to the entire S&P 500. As a reminder, the higher or lower the z-score, the more it varies from the average.

Data courtesy Bloomberg

Results – Total Returns

To calculate returns for the top and bottom 50 stocks, we stretch a bit and assume that the 50 growth and value stocks identified today have been in that realm for the past ten years. While we know that is not entirely the case; it is not unreasonable to think both groups have been in the ballpark. The table below highlights the total returns of each group across various timeframes.

Data courtesy Bloomberg

Conclusions

The contrast in metrics between growth stocks and value stocks could not be starker. The differentials are incredibly large, which indicates one is either paying eye-watering prices for growth, or they are truly finding value in the value category. The total return performance over each time frame highlights the chasm between investor preferences for growth over value since the financial crisis.

Growth stocks have rewarded investors for taking risk and punished those with a tried and true value approach. While memories are nice, we remind you that as investors we must look forward. Value stocks provide a large cushion for error, whereas growth stocks are priced for a level of perfection not since the technology bubble. As long as the market remains euphoric, growth will likely continue to outperform value. However, when rationality strikes the market over the head, the ridiculous prices the market assigns to growth stocks will normalize. At the same time, investors will seek out boring companies with steady earnings and relatively cheap valuations that constitute the value sector.

Value Your Wealth – Part One Introduction

In this article and a series of others to follow, we explore the distinction between growth and value investment styles. Those looking in their rearview mirror will likely laugh at our analysis and focus on what worked yesterday. Those aware of the inevitable turns in the road ahead will understand the unique worth that a value-focused investment style offers.

We believe the market is on the precipice of a monumental shift, and one that will blindside most investors. Through this series of articles, we aim to provide research and investment ideas that will allow you to protect your wealth when the investment cycles shift and thrive when most investors suffer.    

Discipline, Process, and an Appreciation for Cycles

Spring has sprung, flowers are blooming, and pollen is swirling through the air. It’s time to put away our winter boots, scarves, and bulky jackets and replace them with swimming trunks, baseballs gloves and the promise of afternoon naps on the beach.

Investing also has its seasons. Economic and investment cycles alternate between periods where risk-taking and speculating is preferred and periods where conservatism and discrimination are essential. Unlike the seasons, there is no calendar that tells us when these investing cycles begin and end. Nevertheless, an appreciation for history along with an understanding of economic trends, valuations, demographics, and monetary and fiscal policy provides helpful clues.

Awareness of potential changes in economic and market cycles, however vague the timing is, allow us to strategize on how to reposition our portfolios when the change in season appears imminent. Because of vastly different investing environments and associated outcomes, success in building wealth over long time frames requires discipline and a durable investment process. It is important to ride the market higher in the good times, but we can’t stress enough the value of avoiding the inevitable large market drawdowns that erase wealth and the precious time you have to compound it. 

Value vs. Growth

The market’s surge higher since the financial crisis and the governmental and corporate policies used to sustain economic and market growth have been nothing short of extraordinary. In many articles, we discussed topics such as the unparalleled use of monetary policy to prop markets higher, massive fiscal spending designed to keep economic growth positive, how corporations have shunned future growth to buy-back stock, and the substantial shift towards passive investment styles.

As a result of these behaviors and actions, we have witnessed an anomaly in what has historically spelled success for investors. Stronger companies with predictable income generation and solid balance sheets have grossly underperformed companies with unreliable earnings and over-burdened balance sheets. The prospect of majestic future growth has trumped dependable growth. Companies with little to no income and massive debts have been the winners.

Over the past decade, investors have favored passive instruments that track a market or a large swath of the market. By doing so, they have easily outperformed active investors that are doing their homework and applying time-tested fundamental analysis to their investment selection process. This passive behavior is circular in nature and has magnified the growth/value imbalance. The investment world has been turned on its head.

The underperformance of value stocks relative to growth stocks is not unique, but the current duration and magnitude of underperformance are unprecedented. Before embarking on a more detailed discussion, a clear definition of what is meant by growth and value is important.

Growth- Growth stocks represent companies that have demonstrated better-than-average gains in sales and/or earnings in recent years and are expected to continue delivering high levels of profit growth. They are generally higher priced than the broad market in terms of their price-to-earnings and price-to-sales, and their stock prices tend to be more volatile. To help fuel earnings, growth stocks often do not pay out a dividend.

Growth stocks generally perform better when interest rates are falling and corporate earnings are robust. On the other hand, they are also most at risk of losses when the economy is cooling.

Value- A value stock tends to include companies that have fallen out of favor but still have good fundamentals such as dividends, earnings, and sales. Value stocks are lower priced than the broader market, are often priced below similar companies in their industry, and are perceived to carry less risk than the market.

Value stocks generally hold their value better in an economic slowdown, tend to do well early in an economic recovery, and frequently lag in a prolonged bull market. In general they pay above market dividends.

Historical Context – Growth vs. Value

It is important to understand which investment styles have been successful during the post-financial crisis era. Given that we are statistically and logically very likely nearing the end of the cycle, it is even more crucial to grasp what decades of investment experience through all sorts of economic and market climates, not just the last ten years, tells us should be successful in the future. 

The graph below charts ten year annualized total returns (dividends included) for value stocks versus growth stocks. The most recent data point representing 2018, covering the years 2009 through 2018, stands at negative 2.86%. This indicates value stocks have underperformed growth stocks by 2.86% on average in each of the last ten years.

The data for this analysis comes from Kenneth French and Dartmouth University.

There are two important takeaways from the graph above:

  • Over the last 90 years, value stocks have outperformed growth stocks by an average of 4.44% per year (orange dotted line).
  • There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.

To say the post-financial crisis era has been an anomaly is an understatement. The current five-year string of a negative trailing 10-year annualized return differential is the longest on record, and the most recent ten-year return ending last year is the lowest on record at NEGATIVE 2.86%.

When the cycle turns, we have little doubt the value-growth relationship will revert. As the graph above shows, seldom does such reversion stop at the average. To better understand why this is so important, consider what happens if the investment cycle turns and the relationship of value versus growth returns to the average over the next two years. In such a case value would outperform growth by nearly 30% in just two years. Anything beyond the average would increase the outperformance even more.

Summary

This article and the others to follow are not intended to implore you to immediately buy value and sell growth. They will, however, provide you with a road map that allows you to plan, strategize and use discipline in moving to a more conservative, value-based strategy if you so choose.

As mentioned, we will explore this topic in much more depth in coming articles. Already in the works are the following analyses: 

  • A stock screen that discerns between value and growth stocks.
  • A tool to help find funds and ETF’s that provide value versus those that use Value in their name but provide little value.
  • Sector analysis to steer you toward specific industries that tend to have more value stocks than growth stocks.

Value and growth are just two of the many factors to explore. In the future, we will also introduce and discuss others such as momentum and size.

We want to be astute stewards of wealth and safeguard our portfolios so that when the investing cycle comes to an end, we are prepared to take advantage of what the next season has in store. This will help ensure those naps on the beach are not dreams but reality.  

Mature Company Stocks Are NOT Bonds

Like many professional investors, I love companies that pay dividends. Dividends bring tangible and intangible benefits: Over the last hundred years, half of total stock returns came from dividends.
In a world where earnings often represent the creative output of CFOs’ imaginations, dividends are paid out of cash flows, and thus are proof that a company’s earnings are real.

Finally, a company that pays out a significant dividend has to have much greater discipline in managing the business, because a significant dividend creates another cash cost, so management has less cash to burn in empire-building acquisitions.

Over the last decade, however, artificially low interest rates have turned dividends into a cult, where if you own companies that pay dividends then you are a “serious” investor, while if dividends are not a centerpiece of your investment strategy you are a heretic and need to apologetically explain why you don’t pray in the high temple of dividends.

I completely understand why this cult has formed: Investors that used to rely on bonds for a constant flow of income are now forced to resort to dividend-paying companies.

The problem is that this cult creates the wrong incentives for leaders of publicly traded companies. If it’s dividends investors want, then dividends they’ll get. In recent years, companies started to game the system, squeezing out dividends even if it meant they had to borrow to pay for them.

The cult of dividends takes its toll

Take ExxonMobil for example. It’s a very mature company whose oil production has declined nine out of the last ten quarters, and it is at the mercy of oil prices that have also been in decline. Despite all that, Exxon is putting on a brave face and raising its dividend every year. Never mind that it had to borrow money to pay the dividend in two out of the last four years.

I sympathize with ExxonMobil’s management, who feel they have to do that because their growing dividend puts them into the exclusive club of “dividend aristocrats” – companies that have consistently raised dividends over the last 25 years. They run a mature, over-the-hill company with very erratic earnings that have not grown in ten years and that, based on its growth prospects, should not trade at its current 15 times earnings. ExxonMobil trades solely on being a dividend aristocrat.

It is assumed that a dividend that was raised for 25 years will continue to be raised (or at least maintained) for the next 25 years. GE, also a dividend aristocrat, raised its dividend until the very end, when it cut it by half and then cut it to a penny.

In a normal, semi-rational world, dividends should be a byproduct of a thriving business; they should be a part of rational capital allocation by management. But low interest rates turned companies that pay dividends into a bond-like product, and now they must manufacture dividends, often at the expense of the future.

Let’s take AT&T. Today, the company is saddled with $180 billion of debt; its DirecTV business is declining; and it is also losing its bread and butter post-paid wireless subscribers to competitors. It would be very rational for the company to divert the $13 billion it spends annually on dividends, using it to pay down debt, to de-risk the company and to increase the runway of its longevity. But the mere thought of a lowered or axed dividend would create an instant investor revolt, so AT&T will never lower its dividend, until, like GE, its external environment forces it to do so.

There is a very good reason why investors should be very careful in treating dividend-paying stocks as bond substitutes. Bonds are legally binding contracts, where interest payments and principal repayment are guaranteed by the company. If a company fails to make interest payments and/or repay principal at maturity, investors will put the company into bankruptcy. It is that simple.

When you start treating a stock as a bond substitute, you are making the mental assumption that the price you pay is what the stock is going to be worth at the time when you are done with it (when you sell it). Thus, your focus shifts to the shiny object you are destined to enjoy in the interim – the dividend. You begin to ignore that the price of that fine aristocrat might be less, a lot less, when you and the stampede of other aristocrat lovers will be selling it.

For the last ten years as interest rates have declined not just in the US but globally, you didn’t have to worry about that. Dividend aristocrats have consistently outperformed the S&P 500 since 2008.
However, the bulk of the aristocrats’ appreciation came from a single, unrepeatable, and highly reversible source: price to earnings expansion. If you are certain that interest rates are going lower, much lower, then you can stop reading this, get yourself some aristocrats, buy and forget them, because they’ll continue to behave like super-long-duration bonds with the added bonus of dividends that grow by a few pennies a year.

If interest rates rise, the prices of dividend aristocrats are likely to act like those of long-term bonds. The price-to-earnings pendulum will swing in the opposite direction, wiping out a decade of gains.
Analyze management, not dividends

What should investors do? View dividends not as a magnetic, shiny object but as just one part in a multivariable analytical equation, and never the only variable in the equation. Value a company as if it did not pay a dividend – after all, a dividend is just a capital-allocation decision.

I know tens of billions of dollars have been destroyed by management’s misallocation of capital, be it through share buybacks or bad acquisitions. But as corporate management continues trying to please dividend-hungry investors, value will also be destroyed when companies pay out more in dividends than they can afford.

This is why analyzing corporate management is so important. A lot of management teams will tell you the right thing; they’ll sound smart and thoughtful; but their decisions will fail a very simple test. Here is the test: If this management owned 10% or 20% of the company, would they be making the same decisions?
Would GE, ExxonMobil, or AT&T have been run differently if they were run by CEOs who owned 10% or 20% of their respective stocks? It’s safe to say they would have put their billions in dividend payments to a very different, more profitable use.

10 Stocks With Growing Dividends

In the recent report “GE – Bringing Investment Mistakes To Life,” I discussed the basic investor fallacy of “I bought it for the dividend.” 

However, most importantly, as I noted:

“While I completely agree that investors should own companies that pay dividends (as it is a significant portion of long-term total returns), it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress. During the next major market reversion, we will see much of the same happen again.”

As you may already suspect, by looking out our portfolios on the site, we have a preference for high-quality names that also provide dividends. Normally, we screen our database of over 8000 stocks for companies which fit several fundamental and value factors to ensure we are buying top-quality names. However, for today’s purpose of a specific dividend focus, we are looking primarily for companies which are members of the S&P 500 index and have a history of growing their dividends over the last 5-years, a declining payout ratio relative to their earnings per share, and we are taking only the top 10 highest rated stocks.

The criteria for our Dividend screen are:

  • Market Capitalization > $1 Billion
  • Index Constituency: Must Be A Member of the S&P 500 Index
  • Dividend Yield > 1% 
  • 5-Year Dividend Growth Rate > 0
  • Change In Payout Ratio < 0
  • Zack’s Investment Ranking = Top 10

The table below are the 10-candidates which resulted from the latest screening.

The combination of these fundamental measures should yield an excess return over the market during the previous 5-year time frame. The table below assumes that over the last 5-years you bought all 10-stocks and rebalanced them semi-annually.

Over the 21-quarterly rebalancing periods, the portfolio had an annualized return of 14.9% versus the 12.1% for the market. This 2.6% annual outperformance versus the S&P 500 is shown in the charts below.

Even though interest rates have risen from the lows of last year, the price of money has been persistently lower in this economic cycle than it has been in the past. This factor continues to provide support for income-yielding stocks as many investors, including the growing population of retirees, are seeking more stable, fixed income-like returns.

The risk of this strategy is that valuations for many companies, including higher dividend payers, have expanded much more than normal, and is reminiscent of the “Nifty-Fifty” period in the late 1970’s.

While investing in dividend yielding stocks certainly provides an additional return to portfolios, as “GE” should have reminded you, stocks are “not safe” investments. They can, and will lose value, and often much more than you can withstand.

This is why for our “safe money” we continue to use rallies in interest rates to buy bonds which provide both higher rates of income and safety of principal.

(Subscribe to our YouTube channel for daily videos on market-moving topics.)

With valuation and safety being a top concern for investors, especially with markets signaling more troubling technical trends, we continue to believe that the best way for investors to generate capital is to invest in quality businesses trading at a reasonable discount to their intrinsic value. As such, we focus on names which still maintain a reasonable valuation, are consistently growing, and are well founded in their industries. We think these names are more likely to offer investors both the yield they are looking for and are currently trading at prices that provide a reasonable margin of safety.


Disclaimer: Nothing in this post should be construed as an offer to buy or sell any securities. This content is for informational purposes only. Past performance is no guarantee of future results. Use at your own risk and peril.

10-Fundamentally Strong Value Stocks Hitting Our Radar

Trying to find value in an over-valued market is difficult to say the least. This becomes even more problematic when we discuss the issue within the reality of a late-stage economic cycle and the potential for an economic recession.

So, in looking for opportunity at a time where there is a rising unfavorable economic and earnings backdrop, we turned to our database to screen for stocks with a very strict set of fundamental guidelines.

In order for a company to become a watch list candidate it must have:

  • Five-year average returns on equity (ROE) greater than 15%;
  • Five-year average returns on invested capital (ROIC) greater than 15%;
  • Debt-to-equity (D/E) less than or equal to 80% of the industry average;
  • Five-year average pretax profit margin (PM) 20% higher than the industry average;
  • Current price-to-book value multiples(P/B) below historical and industry multiples;
  • Current price-to-cash flow (P/CF) ratios below the industry average

Out of the universe of more than 6,500 issues, only 10 passed the test.

This should immediately ring some alarm bells on the market as a whole with respect to valuations and the risk being undertaken by investors in general.

However, here are the 10 top stocks we are adding to our watch list currently.

*Disclosure: We currently own BA in both our Equity and Equity/ETF portfolio models.
**While REMI made the screening list, it is excluded from consideration due to being under $5/share.

Below I am providing a brief snapshot of each for your own review.

CL

SNBR

DENN

PZZA

  • Warning:  The company is facing numerous class action lawsuits which could have an adverse effect on the company.

ANIK

CBPO

TARO

REMI

  • Warning: This is a sub-$5 stock and is extremely high risk. It is not suitable for investors or our portfolios.

LII

BA

Importantly, just because these companies cleared a screen, such is only the first step in determining if it should be added to an investment portfolio. Each company must be evaluated not only on it fundamental merits but its price trends as well. They should also be evaluated relative to other holdings in your portfolio, your own personal risk tolerance, and your investment objectives.

Disclaimer: As always, you must do your homework BEFORE making any investment. The information contained herein should not be construed as investment advice or a solicitation to buy or sell any security. Past performance is no guarantee of future results. Use of this information is at your own risk and peril. 

8-GARP Stocks That Are Strong Buys

In our previous article we noted that one of the biggest challenges in managing money is finding the right stocks to add to your portfolio. It is hard enough to cull through the 1500 stocks that make up the S&P 500, 400, and 600 indexes much less the more than 6,000 other securities available for investing in.

While we covered dividend income stock last time, this time we thought we would dig around stocks which are trading at a discount to expected growth or, more commonly known as, “Growth At A Reasonable Price.”

GARP investors look for companies that are somewhat undervalued (a feature of value investing) with solid sustainable growth potential (a tenet of growth investing) – an approach that attempts to avoid the extremes of either value or growth investing.

It’s worth noting that we are not talking about owning a portfolio of stocks where some are growth and some are value but rather a portfolio of stocks that on an individual basis have both value and growth characteristics. This is also not to say that you couldn’t combine our value and dividend stocks with growth and value stocks as part of an overall investment strategy.

The criteria for our GARP screen are:

  • Current P/E Divided By The 5-Year Average <= 5
  • Percentage Change Of Next Years Estimates Over Last 12-Weeks >= 0
  • P/E Using 12-Month Forward EPS Estimates <= 15
  • 5-Year Historical EPS Growth (%) >= 5
  • Next 3-5 Years Estimated EPS Growth (%/Year) >= 5
  • Rank = Strong Buy
  • P/E Using 12-Month Forward EPS Estimate >= 8

The table below are the 8-candidates which resulted from the latest screening.

In a market that is fundamentally overvalued, buying value at a reasonable price is become more exceedingly difficult. However, in theory, buying stocks that exhibit both strong value and growth characteristics should yield an excess return over the market over time. The table below assumes that over the last 5-years you bought all the stocks yielded by the screen and rebalanced them quarterly.

(The number of holdings ranged from a low of 6 in July of 2016 to a maximum of 31 following the market rout in February of this year. The last period for the holding period was for May of 2018 which yielded 18 holdings. Following the recent run-up, the number of holdings has been reduced to 8 which is the tied with the second lowest number of holdings since 2013. Note that low holdings preceded the market routs of 2015-2016 and 2018.)

Over the 21-quarterly rebalancing periods the portfolio had an annualized return of 16.6% versus the 13.6% for the market. This 2.7% annual outperformance versus the S&P 500 is shown in the charts below.

Because a GARP strategy employs principles from both value and growth investing, the returns seen during certain market phases can be quite different that returns seen in a strict value or growth portfolio. However, as shown in the portfolio metrics, while a GARP strategy can provide outperformance over the index overtime, given proper risk management practices, but can have higher volatility because of the growth component.

By combing this strategy with a dividend-income strategy as discussed last time, it is possible to smooth out some of the volatility while still maintaining returns.

In short, the GARP strategy not only fuses growth and value stock-picking criteria, but also experiences a combination of their types of returns. While a value investor will do better in bearish conditions; a growth investor will do better in a bull market; therefore, GARP investing should be rewarded with more consistent and predictable returns.

There is no doubt we are in a full-blown bull market currently. However, valuations are suggesting that returns may be significantly lower in the future making a GARP portfolio, and potentially one combined with a dividend strategy, much more beneficial.

(Subscribe to our YouTube channel for daily videos on market-moving topics.)

One of the best known GARP investors was Peter Lynch, who has written several popular books, including “One Up on Wall Street” and “Learn to Earn.” Of course, he was an investing legend due to his 29% average annual return over his 13-year stretch from 1977-1990 as manager of the Fidelity Magellan fund. Of course, the advantage to Peter Lynch was starting his run when valuations were deeply depressed at 7-9x earnings rather than 33x today.

This is why, with valuation and safety being a top concern for our clients, especially with markets at all-time highs, we continue to believe that the best way for investors to generate capital is to invest in quality businesses trading at a reasonable discounts to their intrinsic value. As such, we focus on names which still maintain a reasonable valuation, are consistently growing, and are well founded in their industries.


Disclaimer: Nothing in this post should be construed as an offer to buy or sell any securities. This content is for informational purposes only. Past performance is no guarantee of future results. Use at your own risk and peril.

10 Value-Dividend Stocks In An Overvalued Market

One of the biggest challenges in managing money is finding the right stocks to add to your portfolio. It is hard enough to cull through the 1500 stocks that make up the S&P 500, 400 and 600 indexes much less the more than 6,000 other securities available for investing in.

As you may already suspect, by looking out our portfolios on the site, we have a preference for high-quality names that also provide dividends. We do this by screening our database of stocks for several fundamental and value factors to ensure we are buying top-quality names and then refining that list down to the top-10 dividend payers. We believe that these value stocks, combined with dividends should generate an excess return versus the benchmark index over time.

The criteria for our Fundamental Value Dividend screen are:

  • Market Cap > $1 Billion
  • Dividend Yield > Top 10 
  • Return On Equity > 15%
  • Price To Sales <= 1.5x
  • EPS Growth Over The Last 3-Years > 0

The table below are the 10-candidates which resulted from the latest screening.

You will note that we recently added CVS Health (CVS) to both the Equity and the Equity/ETF models. 

As I stated, the combination of these fundamental measures should yield an excess return over the market over time. The table below assumes that over the last 5-years you bought all 10-stocks and rebalanced them quarterly.

Over the 21-quarterly rebalancing periods the portfolio had an annualized return of 15.6% versus the 13.8% for the market. This 1.80% annual outperformance versus the S&P 500 is shown in the charts below.

Even though interest rates have risen from the lows of last year, the price of money has been persistently lower in this economic cycle than it has been in the past. This factor continues to provide support for income yielding stocks as many investors, including the growing population of retirees, are seeking more stable, fixed income-like returns.

The risk of this strategy is that valuations for many companies, including higher dividend payers, have expanded much more than normal, and is reminiscent of the “Nifty-Fifty” period in the late 1970’s.

While investing in dividend yielding stocks certainly provides additional return to portfolios, just remember that stocks are “not safe” investments. They can and will lose value during a market decline.

This is why for our “safe money” we continue to use rallies in interest rates to buy bonds which provide both higher rates of income and safety of principal.

(Subscribe to our YouTube channel for daily videos on market-moving topics.)

With valuation and safety being a top concern for investors, especially with markets at all-time highs, we continue to believe that the best way for investors to generate capital is to invest in quality businesses trading at a reasonable discounts to their intrinsic value. As such, we focus on names which still maintain a reasonable valuation, are consistently growing, and are well founded in their industries. We think these names are more likely to offer investors both the yield they are looking for and are currently trading at prices that provide a reasonable margin of safety.


Disclaimer: Nothing in this post should be construed as an offer to buy or sell any securities. This content is for informational purposes only. Past performance is no guarantee of future results. Use at your own risk and peril.

UPDATE: Drilling for Value – Southwestern Energy (SWN)

Since recommending Southwestern Energy Company (SWN) for purchase on September 13th, the stock has exceeded our expectations. It currently trades at $5.50, or about 10% above the recommended price.

Given SWN’s extreme volatility, we recommended a stop-loss protection order as follows:  “Using the charts as a framework, one can enter a long SWN position with a downside stop loss of 4.55 (4.70 less a 3% cushion).”

Given the recent surge in price, SWN has put us in a unique opportunity to “play with the houses money.”

We think investors heeding our advice should increase the stop loss from $4.55 to $5.00. This allows us to participate in further upside, assuming the bottoming pattern of higher-highs and higher-lows continues to play out, and at the same time it greatly limits our potential loses.

The original article is below.

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.


We have made it clear on numerous occasions that there are not many value propositions available in the equity markets for long-term shareholders. Most recently in Allocating on Blind Faith, we highlighted how three widely followed valuation levels portend low single-digit returns for the coming decade. While a dismal outlook that does not mean that opportunities do not exist.

One asset class in particular that continues to catch our attention is commodities. The following graph shows how cheap the Goldman Sachs Commodity Index (GSCI) has become compared to the S&P 500. In the same way that a metal detector can identify the location of possible treasures, this graph provides a strong signal there is potential value in commodity-linked investments. Those inclined must simply “dig.”

Within the commodity sector, we have a few stocks that are on our watch list for possible investment. In this article, we explore one of them, Southwestern Energy Company (SWN). SWN is a natural gas exploration and production company headquartered in Texas. It is somewhat unique in the energy sector as it is one of a few publically traded companies that are almost entirely focused on natural gas. Most of SWN competitors have much higher exposures to oil and other energy products. In 2017, for instance, 97% of SWN’s revenue was derived from the production, transportation, and marketing of natural gas (NG).

By using both a technical and fundamental examination, we can better assess whether SWN is worth owning.

Technical Study

We start our technical study with a short-term graph covering the last 12 months and then expand further back in time for a broader context as to where SWN has traded, relevant trends, support and resistance levels, and what that might portend for the future.

SWN appears to have bottomed following a significant decline over the last few years. There is reason to believe a true bottom has formed as shown in the one-year graph below. Three bullish buy signals based on the Moving Average Convergence Divergence (MACD) indicator have occurred as indicated by the dotted vertical lines. Additionally, the 50-day moving average crossed over the 200-day moving average in July. Further a strong support line (gold dotted line) has formed and has been tested successfully on numerous occasions. Currently, the support line is near $4.70 which provides a solid level to establish risk parameters for a potential trade. That price level, less a 3% cushion ($4.55), should serve well as a stop loss acting as a trigger to reduce or eliminate the position and risk if SWN closes below that price level.

The longer term, 10-year chart below provides a different perspective of SWN. Since 2014, SWN has declined by almost 90%. However, since March it has shown signs of bottoming. While the shorter-term chart leaves room for optimism, the longer-term chart certainly gives reason for pause.

The current price ($5.00) is not far from the 3-year downtrend resistance line ($5.74) which has capped every rally since 2014.  If SWN were to convincingly close through that 3-year resistance line, it would greatly improve our longer-term confidence and appetite for risk.

Also of concern, the stock is considered overbought based on the Williams % Ratio (momentum indicator). We are not overly concerned with the Williams % Ratio as the ratio can stay at extreme levels for long periods without resulting in a meaningful change in the direction of a security’s price.

If SWN is reversing the decline of the prior years, we would like to see it establish a pattern of higher highs and higher lows. Thus far, that has only recently begun to occur but six months certainly does not make a dependable trend.

The technical picture for SWN is tilted somewhat favorably as it allows us to establish guardrails for taking additional risk. Using the charts as a framework, one can enter a long SWN position with a downside stop loss of 4.55 (4.70 less a 3% cushion). At the same time, if the upside trendline is broken the next price target is the November 2017 high of 6.72. The gain/loss ratio of the potential short-term upside target (6.72) to the downside stop loss target (4.55) is over 4:1, a compelling data point.

Fundamentals

The sharp decline in the share price of SWN compressed the valuation multiples that investors were willing to pay. In 2007, for instance, SWN’s price to sales ratio was over 10. Since then it has steadily eroded to its current level of 1. Price to trailing 12 months earnings (P/E) has also cheapened significantly, having steadily dropped from the mid 20’s to its current level of 8.80.

As a point of comparison, consider that SWN reported revenue of $763.11mm and EBITDA of $397.17mm in the fourth quarter of 2006. In the most recent earnings release, revenue was reported at $3,282mm (3.3x greater than 2006) and EBITDA was $914mm (1.3x greater than 2006). At the same time, the market cap (number of shares outstanding times the stock price) is currently $3,296mm versus $5,897mm at the end of 2006. Simply put, investors are getting a lot more for their money than in prior years.

From a liquidity perspective, SWN total liabilities have declined significantly over the last four years. Its ratio of long-term debt to equity now stands at 158% versus over 1000% in 2015. While financial leverage is not as great as it was, we are in turn provided a greater level of comfort in their ability to service the debt.

Among the many fundamental indicators we use to evaluate stocks for inclusion in our portfolios, two are worth emphasizing. They are the Piotrosky F Score and Mohanram Score.

  • The Piotrosky F Score uses nine factors to determine a company’s financial strength in profitability, financial leverage and operating efficiency. Currently, SWN scores a very favorable 8 on a scale of 1 to 9.
  • The Mohanram Score uses eight factors to determine a company’s financial strength in earnings and cash flow profitability. SWN scores a 5 on a scale of 1 to 8.

Of additional interest Zacks has strong ratings in various metrics as follows:

  • Zacks Rank 2  (1-5, 1 being the highest)
  • Growth Score B (A-F, with A being the highest)
  • Value Score A (A-F, with A being the highest)
  • Momentum Score A (A-F, with A being the highest)
  • VGM Score A (A-F, with A being the highest)

SWN is trading at a much cheaper valuation compared to years past. That said, we must remain vigilant as SWN relies on one product, NG. Swings in the price of NG due to ever-changing supply and demand variables can be violent and earnings can change sharply.

Seasonals

Our time-tested, long-range formula is pointing toward a very long, cold, and snow-filled winter,” -Peter Geiger in a statement on the Farmers’ Almanac website.

We start this section with the obvious disclaimer that we are not weathermen. Nor would we recommend an investment based on a weather forecast. That said the weather outlook can greatly affect sentiment and the demand for NG and therefore affect SWN’s earnings and stock price.

In the short run, it behooves us to understand how the expectations for a cold winter, as is expected by some long-range meteorologists, and the potential for rising NG prices might affect the price of SWN. The graph below shows a significant one-year rolling correlation between the prices of NG and SWN and therefore short-term holders should consider that weather could easily play an outsized role in the pricing of SWN.

Next, we compare how NG has performed by month. In particular, we are looking for seasonal outperformance or underperformance patterns in respective months that might be weather-related.

As shown, NG has produced the highest average gains in September and October over the past 27 years. This is likely due to a combination of pre-winter expectations for higher NG prices as well as hedging activity taking place in NG. Further, those months were also affected in certain years by seasonal hurricane activity which can temporarily boost the price of NG.

Interestingly, note that the months of January and February, despite what is frequently peak NG usage, tend to be poor months for NG price performance. The winter months are when the rubber hits the road and NG prices fail, at times, to live up to the expectations formed in the summer and fall months.

Given SWN’s strong correlation to NG, we should keep these seasonal tendencies in mind.

Summary

In a market dearth of value, we think SWN provides an interesting opportunity. While its longer-term trend is poor, its recent trading performance and solid fundamentals provide what appears to be a constructive asymmetry of risk and reward. Further seasonal patterns in NG and speculative forecasts for a cold winter argue for a boost in the short-term.

On the basis of those factors, SWN appears more than fairly priced and cheap compared to most other stocks with a compelling upside-to-downside ratio. Despite the seasonal volatility associated with the weather, the fundamentals argue that SWN represents decent value and might prove to be a good long-term hold. Further, it provides some measure of diversification as it tends to be poorly correlated with the stock market.

All data in the article was provided by Zacks and the graphs from Stockcharts.com

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.

Drilling for Value – Southwestern Energy (SWN)

We have made it clear on numerous occasions that there are not many value propositions available in the equity markets for long-term shareholders. Most recently in Allocating on Blind Faith, we highlighted how three widely followed valuation levels portend low single-digit returns for the coming decade. While a dismal outlook that does not mean that opportunities do not exist.

One asset class in particular that continues to catch our attention is commodities. The following graph shows how cheap the Goldman Sachs Commodity Index (GSCI) has become compared to the S&P 500. In the same way that a metal detector can identify the location of possible treasures, this graph provides a strong signal there is potential value in commodity-linked investments. Those inclined must simply “dig.”

Within the commodity sector, we have a few stocks that are on our watch list for possible investment. In this article, we explore one of them, Southwestern Energy Company (SWN). SWN is a natural gas exploration and production company headquartered in Texas. It is somewhat unique in the energy sector as it is one of a few publically traded companies that are almost entirely focused on natural gas. Most of SWN competitors have much higher exposures to oil and other energy products. In 2017, for instance, 97% of SWN’s revenue was derived from the production, transportation, and marketing of natural gas (NG).

By using both a technical and fundamental examination, we can better assess whether SWN is worth owning.

Technical Study

We start our technical study with a short-term graph covering the last 12 months and then expand further back in time for a broader context as to where SWN has traded, relevant trends, support and resistance levels, and what that might portend for the future.

SWN appears to have bottomed following a significant decline over the last few years. There is reason to believe a true bottom has formed as shown in the one-year graph below. Three bullish buy signals based on the Moving Average Convergence Divergence (MACD) indicator have occurred as indicated by the dotted vertical lines. Additionally, the 50-day moving average crossed over the 200-day moving average in July. Further a strong support line (gold dotted line) has formed and has been tested successfully on numerous occasions. Currently, the support line is near $4.70 which provides a solid level to establish risk parameters for a potential trade. That price level, less a 3% cushion ($4.55), should serve well as a stop loss acting as a trigger to reduce or eliminate the position and risk if SWN closes below that price level.

The longer term, 10-year chart below provides a different perspective of SWN. Since 2014, SWN has declined by almost 90%. However, since March it has shown signs of bottoming. While the shorter-term chart leaves room for optimism, the longer-term chart certainly gives reason for pause.

The current price ($5.00) is not far from the 3-year downtrend resistance line ($5.74) which has capped every rally since 2014.  If SWN were to convincingly close through that 3-year resistance line, it would greatly improve our longer-term confidence and appetite for risk.

Also of concern, the stock is considered overbought based on the Williams % Ratio (momentum indicator). We are not overly concerned with the Williams % Ratio as the ratio can stay at extreme levels for long periods without resulting in a meaningful change in the direction of a security’s price.

If SWN is reversing the decline of the prior years, we would like to see it establish a pattern of higher highs and higher lows. Thus far, that has only recently begun to occur but six months certainly does not make a dependable trend.

The technical picture for SWN is tilted somewhat favorably as it allows us to establish guardrails for taking additional risk. Using the charts as a framework, one can enter a long SWN position with a downside stop loss of 4.55 (4.70 less a 3% cushion). At the same time, if the upside trendline is broken the next price target is the November 2017 high of 6.72. The gain/loss ratio of the potential short-term upside target (6.72) to the downside stop loss target (4.55) is over 4:1, a compelling data point.

Fundamentals

The sharp decline in the share price of SWN compressed the valuation multiples that investors were willing to pay. In 2007, for instance, SWN’s price to sales ratio was over 10. Since then it has steadily eroded to its current level of 1. Price to trailing 12 months earnings (P/E) has also cheapened significantly, having steadily dropped from the mid 20’s to its current level of 8.80.

As a point of comparison, consider that SWN reported revenue of $763.11mm and EBITDA of $397.17mm in the fourth quarter of 2006. In the most recent earnings release, revenue was reported at $3,282mm (3.3x greater than 2006) and EBITDA was $914mm (1.3x greater than 2006). At the same time, the market cap (number of shares outstanding times the stock price) is currently $3,296mm versus $5,897mm at the end of 2006. Simply put, investors are getting a lot more for their money than in prior years.

From a liquidity perspective, SWN total liabilities have declined significantly over the last four years. Its ratio of long-term debt to equity now stands at 158% versus over 1000% in 2015. While financial leverage is not as great as it was, we are in turn provided a greater level of comfort in their ability to service the debt.

Among the many fundamental indicators we use to evaluate stocks for inclusion in our portfolios, two are worth emphasizing. They are the Piotrosky F Score and Mohanram Score.

  • The Piotrosky F Score uses nine factors to determine a company’s financial strength in profitability, financial leverage and operating efficiency. Currently, SWN scores a very favorable 8 on a scale of 1 to 9.
  • The Mohanram Score uses eight factors to determine a company’s financial strength in earnings and cash flow profitability. SWN scores a 5 on a scale of 1 to 8.

Of additional interest Zacks has strong ratings in various metrics as follows:

  • Zacks Rank 2  (1-5, 1 being the highest)
  • Growth Score B (A-F, with A being the highest)
  • Value Score A (A-F, with A being the highest)
  • Momentum Score A (A-F, with A being the highest)
  • VGM Score A (A-F, with A being the highest)

SWN is trading at a much cheaper valuation compared to years past. That said, we must remain vigilant as SWN relies on one product, NG. Swings in the price of NG due to ever-changing supply and demand variables can be violent and earnings can change sharply.

Seasonals

Our time-tested, long-range formula is pointing toward a very long, cold, and snow-filled winter,” -Peter Geiger in a statement on the Farmers’ Almanac website.

We start this section with the obvious disclaimer that we are not weathermen. Nor would we recommend an investment based on a weather forecast. That said the weather outlook can greatly affect sentiment and the demand for NG and therefore affect SWN’s earnings and stock price.

In the short run, it behooves us to understand how the expectations for a cold winter, as is expected by some long-range meteorologists, and the potential for rising NG prices might affect the price of SWN. The graph below shows a significant one-year rolling correlation between the prices of NG and SWN and therefore short-term holders should consider that weather could easily play an outsized role in the pricing of SWN.

Next, we compare how NG has performed by month. In particular, we are looking for seasonal outperformance or underperformance patterns in respective months that might be weather-related.

As shown, NG has produced the highest average gains in September and October over the past 27 years. This is likely due to a combination of pre-winter expectations for higher NG prices as well as hedging activity taking place in NG. Further, those months were also affected in certain years by seasonal hurricane activity which can temporarily boost the price of NG.

Interestingly, note that the months of January and February, despite what is frequently peak NG usage, tend to be poor months for NG price performance. The winter months are when the rubber hits the road and NG prices fail, at times, to live up to the expectations formed in the summer and fall months.

Given SWN’s strong correlation to NG, we should keep these seasonal tendencies in mind.

Summary

In a market dearth of value, we think SWN provides an interesting opportunity. While its longer-term trend is poor, its recent trading performance and solid fundamentals provide what appears to be a constructive asymmetry of risk and reward. Further seasonal patterns in NG and speculative forecasts for a cold winter argue for a boost in the short-term.

On the basis of those factors, SWN appears more than fairly priced and cheap compared to most other stocks with a compelling upside-to-downside ratio. Despite the seasonal volatility associated with the weather, the fundamentals argue that SWN represents decent value and might prove to be a good long-term hold. Further, it provides some measure of diversification as it tends to be poorly correlated with the stock market.

All data in the article was provided by Zacks and the graphs from Stockcharts.com

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.