After the financial markets took a collective header in 2008, it seemed as if the entire world was one great big value investment. The S&P 500 and the Russell 3000 had both plunged about 40% as of early December, many overseas indexes fared even worse, and some of the bluest of blue chips traded at multiyear or, in some cases, multi-decade lows (giving new meaning to the concept of "blue" chips). For investors with the money and stomach to jump back in, picking through the markdowns was like shopping at Value Village.
"There's value sitting on the sidewalk just ready to be picked up," says Donna Renaud, co-manager of the Northern Large Cap Value fund. "But you have to be careful because there will be some real winners and losers in this market."
In other words, beware of value traps. "Just because stocks have come down a lot doesn't mean they're extraordinarily cheap," says Peter Langerman, CEO of Franklin Templeton Investment's Mutual Series funds. "Their business and balance sheet might've deteriorated significantly and they need to raise more capital. It's not a given that a stock that's fallen by 60% is cheap."
The S&P 500 in early December traded at 10.45 times estimated 2009 earnings, or almost half the historic average multiple of 19.3. But earnings estimates are coming down significantly and aren't always the best gauge of a company's worth, notes Standard & Poor's index analyst Howard Silverblatt. "If you're looking for value, you have to look at assets, cash flow and, in the words of Warren Buffett, products you can understand in less than two sentences," he says.
Indeed, certain valuation metrics other than earnings suggest that there are a lot of blue-light specials out there. "When you look at cash flow and dividend yields relative to Treasurys, the stock market as a whole looks very cheap," says Dave Hintz, head of U.S. equity research at Russell Investments. "The valuations are very attractive to value managers, and they do think that in three to five years we'll look back and be amazed at the value available in this year's market."
Value investing can mean different things to different people, but one thing is certain: stick-to-your-discipline, don't-follow-the-herd value investing isn't easy, particularly during bullish manias. "You will be short of social acceptance for extended periods of time," says Matthew McLennan, a portfolio manager at the First Eagle Global and Overseas funds. "You often have to avoid what's fashionable."
McLennan says First Eagle took a lot of flak for not buying into the tech bubble, and he admits it was painful not to chase Chinese equities and commodities in 2007. But First Eagle funds were among the few non-hedge funds with positive returns in 2002, and through the end of November 2008 the company's five funds collectively outperformed its category average by roughly 14 percentage points, according to Morningstar.
"Value is having the humility to acknowledge that the future is uncertain," McLennan says. "It means investing in a manner to preserve capital and it requires a valuation margin in safety reflected in a low price to demonstrated historical earnings power of a business versus future earnings power."
Value investing, say its proponents, isn't about picking up damaged goods at rock-bottom prices with hopes of cashing in on a dead-cat bounce. "At times, I get somewhat prickly about the definition of value and trying to put value investors into a box," says William Browne, a managing director at fund manager Tweedy, Browne Company. "As we see it, value is a simple conceptual framework, and I think its relevance is coming back in spades."
Browne says it boils down to noted value investor Benjamin Graham's big simple idea-forget about the stock and focus on the business. In other words, an "investor" calculates the worth of a stock based on the value of a company's underlying business, while "speculators" base the value on the market price.
"I think we'll come back to a point where some thoughtfulness, common sense and underlying ownership in something will become more valued in the process," Browne says.
His fellow managing director, Robert Wyckoff, says Tweedy, Browne typically buys companies at a 33% to 40% discount below what they think the business would go for if it's purchased outright. "Depending on the business, we see a lot change hands at 10 times earnings before interest and taxes [EBIT]," he says. "So if we can buy in at six to seven times, we're getting a healthy discount to what we think is the real-world value of the business.
"One of the things that gives value investors like us an edge is the willingness to look further out and to own a business over a longer time period," Wyckoff continues. "I think a lot of people try to capture modest inefficiencies by jumping in and out of the markets by using derivatives and the like on a short-term basis. I think the bigger inefficiencies are available when you're willing to look further out."
Among the golden rules espoused by the patron saint of value investing, Benjamin Graham, is that bargain stocks should sell for less than a company's net working capital, or current assets minus its total liabilities. In addition, he noted in one of his seminal books, The Intelligent Investor, that investors should demand stocks trading at a "satisfactory" price-to-earnings multiple (he suggested no more than 25 times a company's average earnings over the past seven years, and not more than 20 times those of the prior 12 months), have strong financial positions, and have long-term earnings potential. They also should have a history of continuous dividend payments, and he suggested that investors limit their equity universe to large-cap companies. These criteria, he acknowledged, virtually eliminated the entire growth stock category.
That said, the lines between growth and value are increasingly blurred and had been even before the market tanked, so value investors got clobbered along with the rest of the market. (In a hollow victory, the Russell 3000 value index's 41% loss as of early December beat the comparable growth index by three percentage points.)
"The notion of value is abstract anyway, but in this type of down environment, value has to sustain itself because whatever theoretical value there is might get extinguished," says Langerman from Franklin Templeton. "For example, in a better credit environment a leveraged company with a weak balance sheet can do things to sell assets and restore their balance sheets. This market is unforgiving and will probably remain so for a while for companies trying to turn themselves around. More than ever, you have to ask if a company can sustain itself in a period of deep global recession. Is there a leverage issue that can wipe out a company's ability to right the ship? You have to understand the companies you own."
Langerman recently was investing in leveraged loans made by commercial banks, investment banks and hedge funds wanting to finance leveraged buyouts. He says prices for these loans dropped for both fundamental and technical reasons, and that they're generally the most senior pieces of paper in the companies' capital structures. "These companies will either recover and debt will trade at increased levels, or ultimately they may be restructured and senior debt will convert to other pieces of paper or to equity. Equities face headwinds because of larger macro issues. But when you get into this part of the capital structure, there's a better risk-reward profile."
Renaud, the Northern Large Cap Value fund manager, says stocks in her fund need to pay at least a 2% dividend yield. "Typically, we have 200 to 250 names in our universe to screen," she says. "We've got many more than that now, some we'd never typically be able to invest in because they didn't have a 2% dividend yield."
This includes tech companies, a sector usually not found in the fund because they generally don't pay dividends, and those that do tend to be too pricey. "Some share prices are so low we've been able to add some of the best names," Renaud says. Among her recent tech holdings were Analog Devices and Linear Technology, which had respective dividend yields of 4.8% and 4.3% as of early December.
First Eagle's McLennan sees value in Japanese industrial companies that recently traded at a few times EBIT. Among them is SMC Corp., a global leader in pneumatics used in light manufacturing. It had net cash on the balance sheet and traded at low-single-digit multiples of its operating profits.
First Eagle is bullish on Japan as a whole, in part because the country avoided a lot of the excesses from the credit bubble (after it suffered deflation for more than a decade). The result: Many of the country's banks have loan-to-deposit ratios of less than one and many companies have conservative balance sheets. "There's a lot of real R&D being done in Japan, and it has a good education system and conservative balance sheets," McLennan says. "We think at less than one times book value, Japan represents a great opportunity for long-term investors."
McLennan also likes software giant Microsoft. "Microsoft trades at 9.5 times estimated earnings and at a mid-single-digit multiple to operating profits," he says. "Its business is relevant to tomorrow despite threats from Google, Linux and Apple."
Connor Browne, co-manager of the Thornburg Value fund, says his fund invests in three different types of stocks--in basic value companies, in consistent earners and in emerging franchises. A basic value name is typically an out-of-favor cyclical company with a beaten down stock price, and Browne says the trick is figuring out whether the problem is temporary or permanent.
One of Browne's current favorites in that category is Corning, the specialty glass and ceramics maker whose stock recently plunged nearly 70% from its 52-week high and was trading at a low p/e multiple of roughly 8.5 times 2009 earnings. Browne likes Corning because it's the dominant supplier of glass to the LCD television market, with a roughly 60% market share. Even though global TV sales slumped during the downturn, he sees a nice secular trend among TV sales away from cathode-ray tubes-and, to some extent, plasma screens-toward LCD units. And he says Corning has enough net cash-about $3 a share-to withstand a lengthy downturn.
"Corning is taking charges as it takes capacity out of the system in the face of slowing demand," Browne says. "It won't take a recovery in the end market for Corning to recover. It just needs future negative expectations to correct themselves somewhat."
If Browne is right, then Corning could be one of many companies, seemingly in the bargain bin, that could rocket from the mire to the moon when the economy eventually recovers. "What's interesting is some of the most beaten up cyclical companies can have the fastest earnings growth in the recovery."