Bargains can be a wonderful thing. People love getting a $100 pair of jeans for $50 -- or a bottle of wine or anything else likewise discounted. The exception to this has always been stocks. When a coveted $40 stock goes to $20, it suddenly gets shunned, and that’s been especially true lately.
Cheap stocks -- the stuff we Value investors look for -- have been shunned for an unusually long time while expensive stocks have been cherished. It sounds crazy that people prefer buying high to buying low, but you can depend on it happening. That’s why Value investing works. The propensity of the majority to buy what’s popular and ignore what’s downtrodden creates bargains, and those willing to step in get rewarded. Since 1926, cheap stocks have outperformed expensive ones by 4.6% a year on average – not year in and year out, but over time.
The problem for Value investors today is that Value has not been rewarded since 2007. There always have been periods when Value has underperformed Growth, and Value investors are prepared to endure these periods. But this has been the longest dry spell for Value since 1926. Barron’s wrote not too long ago that, “Value investors have been waiting nearly as long as the Mets and the Cubs for a winning season.” And while the Mets and Cubs have gotten a shot at redemption, Value investors still haven’t.
What has happened? One possibility is that Value investing doesn’t work anymore because there’s been a permanent change in the way people and markets behave. We think this is highly unlikely, but it’s something we’ve got to be prepared for. Another more likely possibility is that this is just an unusually long period of expensive stocks outperforming. Expensive stocks often become popular when the fear of missing out drives prices ever higher, like during the1990s internet boom. Today though, it seems that deep uncertainty about a fragile post-crisis world is making people feel safer with expensive stocks.
We think this will turn. In fact, we think this is a market ripe for Value to reassert itself because things have gotten so out of whack with previous periods. Large stocks have trounced small ones. Dividend payers, which over the long term do better than the market, are doing worse. And a narrow handful of stocks that are either very large or exceptional franchises have been holding up the entire market. The S&P 500 is up about 3% through November this year, but if we took 8 stocks out -- Amazon, Google, Facebook, Microsoft, GE, Apple, Disney, and Home Depot -- the index would be negative. And as the chart here shows, while the S&P 500 at the end of November was still just 2% off its 52-week high, nearly a third of its component stocks were down more than 20% -- something the headline number doesn’t capture.
We know that imbalances in the market can last longer than expected. Our experience is that people lose patience at exactly the wrong time, when things seem darkest. Unless human behavior has radically changed, giving up now would be the wrong thing. This doesn’t mean we indiscriminately buy stocks with falling prices. When we look for bargains, we also ask the following: 1) Does the company have a moat or a durable economic advantage? 2) Does the company generate sufficient free cash flow relative to its price? 3) Has the company made returns on its invested capital – that is, has it used its money wisely? And 4) Can the company pay back its debt even while going through hard times?
All of these factors speak to the fact that in the end, stock prices are driven by cash flows. Prices may zig or zag for shorter times, but when a company’s cash flow generation gets recognized, it gets rewarded.