On the hot, miserable afternoon of July 19, with the Dow Jones Industrial Average en route to its seventh-biggest point drop in history, value manager Brian Barish threw up his hands and said, "I can name two dozen stocks in my portfolio that are really cheap and which I can't believe people are selling at these prices. The market has absolutely fallen apart in its ability to comprehend what's going on."
Although distraught, the president of Denver's Cambiar Investors LLC wasn't going berserk. "The important thing is not to lose sight of your discipline," he says. "Our job as value managers is to identify where value is-where people are throwing the baby out with the bath water by looking at situations excessively conservatively-and to try to capitalize on that."
The next week, his point was proved, at least temporarily. One of Barish's high-conviction picks, Abbott Laboratories, which had been mashed to a P/E not seen since the first Reagan term, jumped 20%.
It's no secret that over the last two years, value (as measured by the Russell 2000 value index of small-cap U.S. stocks) has outperformed other investment styles, making it the style du jour. However, a glance at a Callan chart-that table with different colored boxes ranking investment styles-reveals that a winner, when it falls, often tumbles to the cellar. Could value's number be up?
Not if investors continue to ignore traditional valuation metrics, as the case of Abbott shows. Value investing (to oversimplify) relies on fundamental analysis to unearth great companies at cheap prices. Yet such analytics were all but forgotten in the late-'90s euphoria, according to Bill Nygren, manager of the Oakmark Select Fund. "People got lazy," he says. "You have to read all the financial statements over a period of history. There isn't a way to simplify (the analysis) and make it easy."
The reason for the homework is that cheap stocks usually have warts. The value investor must therefore determine whether the blemish is temporary/inconsequential or serious/permanent. For example, when Rent-Way Inc. was hit with an accounting issue, SAFECO Small Company Value Fund Manager Greg Eisen studied the matter while the market punished the stock. The company's problem related only to costs, Eisen found out, and using his knowledge of the unglamorous rent-to-own industry (not much studied by the bourgeois Street anyway), his revised earnings projections showed significant upside potential in the pummeled equity. Rent-Way is currently Eisen's largest holding.
Similarly Wally Weitz, manager of two value funds for Wallace R. Weitz & Co. in Omaha, bought financial stocks when the Fed was raising rates in 1990, '94 and '99, which causes Wall Street to automatically dump banks and financials. "But sure enough, six or nine months later the rates stop going up, the earnings don't disappear, and the (stocks) come back," Weitz says.
Regarding theory, there are two schools of value investing: deep value, which seeks the cheapest issues, and relative value, where a stock is underpriced relative to peers or historical financial measures. The premise underlying both is that buying inexpensively will benefit you if reversion to mean value occurs. Although you might assume otherwise, the opposite of value is not growth. "It's over-valued," says Erin Bellissimo, director of Columbia University's Heilbrunn Graham and Dodd Center for Investing.
Despite the stock market's early summer nosedive, value managers are having trouble finding stocks to get excited about. Nygren's approach is to buy stocks trading at not more than 60% of his calculation of the business's intrinsic value (and to sell at 90%), but he's finding fewer undervalued equities today than at the height of the bull market. "It's harder for us to find attractive ideas even though the market is lower," Nygren says.
Bernard Horn, president of Polaris Capital Management, is almost as dour. Horn's primary valuation metric is operating cash flow, which has fallen at many companies along with the stock price. So, shares remain overvalued. "For example, we've been studying the energy business lately, hoping to find some good values there," Horn says. "But most of the analyst estimates that we see take last year's cash flow and grow it by 5% or 10% to get next year's estimate, which makes it look like a better value because next year's earnings will be better than this year's and therefore the multiple is lower going into next year." But if you do the revenue model correctly, Horn says, by accounting for flat production and today's lower oil prices, sales (and, hence, operating cash flow) project lower. "We think that during the second-quarter earnings releases this summer, a lot of earnings projections are going to come down pretty dramatically," Horn said in mid-July. Two weeks later, Mirant Corp., a NYSE-listed global energy concern whose stock has been decimated, noted that factors including soft pricing are expected to lower previous earnings guidance for 2003.
What the sagging market has done is change the types of companies that are showing up on value managers' radar screens. "A lot of the newer opportunities have been large-cap names outside the technology sector that used to be owned in the growth funds," says Nygren. "Industry leaders that used to sell at 25 to 30 times earnings (are) priced in the teens. In the pharmaceutical industry, Merck, Schering-Plough, Bristol and Abbott Labs have all come down in price to where they've either made it into our portfolio or they're on the list of names we're seriously researching." Likewise for Safeway, a leader in the supermarket industry, trading at 11 times earnings.
Of course, just because a stock has fallen from growth's grace doesn't mean it can't continue to drop in the value manager's hands. Since the late '90s, value investors have been confronted with what has come to be called the classic value trap-a company with a strong brand name selling at a reasonable price facing an eroding business franchise, such as JC Penney or Tupperware. Still, seasoned value investors believe that by conscientiously adhering to their time-tested stock-selection criteria and examining the company's business operations, some value investments can reposition themselves in a challenging competitive environment.
Then there are falling stars, like WorldCom, which drop into value territory only to keep on descending. When analyzing fallen-angel growth stocks, focus on the balance sheet, advises Ross Margolies, head of Citigroup Asset Management Hedge Fund and Specialty Product Group. Look for a lot of cash so that the company won't have to issue new shares at today's depressed prices, and avoid companies with putable convertibles (which require the issuer to convert them into equity) for the same reason. "You have to watch out for dilution," says Margolies. "Nortel issued 20% to 25% of its equity-and diluted you-at $1.41." If a company can forestall equity offerings, you'll benefit, he says.
From that perspective, it's not surprising that Margolies likes cash-rich biotech, a downtrodden growth arena that spotlights the market's inattentiveness to fundamentals. "I never thought in my career that I'd see companies trading at a discount to cash, because I thought with all this information (available), everybody would jump all over them," he says. "(Buy the) cash, and you get the business for free."
Growth utilities (yes, you read that right) have the attention of Kenneth Enright, senior vice president at MFS Investment Management in Boston. According to Enright, P/Es in the natural gas and electric utility space have historically ranged from about 11 for the plain-vanilla utilities to 35 for firms that are generators. But that spread has collapsed (due in part to Enron tainting the industry) to a range of seven to 12. To Enright, that reeks of opportunity for decompression of multiples. El Paso Corp. is one name he likes.
Meanwhile Robert Lyon, manager of ICAP Select Equity Fund, is trolling for media stocks that have tumbled. "We think media is the sweet spot of the collapsed TMT (technology, media, telecommunications) area," he says, noting that the recent upfront season for buying fall advertising on broadcast television was better than expected. "The cable upfront season was solid. The movie business, and people buying DVDs and having their libraries converted into DVDs-that's all going strong. The music business is a weak spot, but in general the media area is rebounding nicely," says Lyon, who is adding to positions in Liberty Media and News Corp. "Even stocks like AOL, Clear Channel and Viacom that have traditionally been too high for us are beginning to get into range," Lyon says.
Liberty Media, it seems, is a favorite. Citigroup's Margolies views the company as "a gigantic portfolio of assets, some of which are not very well-understood by people, some of which are hedged in a way that is not very well-understood. We think there's $18 or $20 [per share] of assets, and we're buying it at $9. So we're paying 50 cents on the dollar, and we think the dollar is growing." Adds Nygren: "We've been an investor with [Liberty Media Chairman] John Malone for over a decade. I think he's one of the best financial and strategic minds in his industry, and he has always found a way to make money. We think it's a great opportunity."
Another beaten growth area beckoning to value is brokerage and investment banking. Goldman Sachs, Merrill Lynch and Morgan Stanley have all bubbled up on Lyon's radar. Earnings are a little soft, he concedes, but costs are under control. "As the economy and business pick up, we think Goldman is in the best position because of their big European franchise, and they've got the highest-margin business. They're not dragged down by retail brokerage or the credit-card business," Lyon says.
Of course, the economy is not in a total funk. Some companies are doing just fine. Barish, the Denver portfolio manager, recently bought ACE Limited, a multi-line property and casualty insurer with a sizeable reinsurance business. Barish pegs 2003 profits at $4 and $4.30 per share, and bought it around $30, under eight times forward earnings. Insurance is not a high multiple sector, to be sure, but P/Es of 11 to 12 are more appropriate. "Due to an increase in overall perceived risk following 9/11, there's an increase in demand for insurance products, so you have tremendous industry pricing," Barish says. "Companies are going to add tons of capital to their businesses."
Horn, meanwhile, sees U.S. health care as attractive, citing Anthem Inc., a demutualized collection of Blue Cross/Blue Shield plans that's working toward overcoming the industry's administrative and information-sharing inefficiencies. "The health care system, if you really get to know it well enough, is not a pretty sight," says Horn. "The average cost of delivering health care is much higher than it should be." So efficient providers who can deliver service at below-average cost while charging the (inflated) market price net an earnings premium and generate strong cash flow. Anthem is also involved in intervention strategies, Horn reports. "Five percent of patients consume about 25% of the health care cost in this country. So getting a handle on who those patients are, and intervening before they get to an acute stage, is a very important part of containing health care costs. We think Anthem could be the biggest health care provider in the country in 10 years," he says, adding that although America's demographics are clearly favorable for health care, not all players will survive.
As investors ultimately learned from the so-called New Economy of the late '90s, things actually were not "different this time." Fundamentals still counted, at the end of the day. Just as people mistakenly overlooked, in their rush to own the technology of tomorrow, nuisance details like, um, earnings streams, one shouldn't eschew the basics when sourpusses commandeer the market.
As for whether value will outperform growth this year, Polaris' Horn makes a good case it will, although as manager of two value funds, that's obviously his bias. Yes, value has beaten growth the last couple of years, but the typical cycle lasts three to four years, Horn says. "If you look over the last 20 years or so, that's been the periodicity." However, the last cycle was about six years in favor of growth, the way Horn counts it.
"You probably should shift to growth stocks when the economy starts delivering growth that was unexpected," Horn says. "Right now, people's expectations seem to be for more growth than the economy is able to deliver. In that kind of environment, I think value stocks are going to outperform."