Such advances have made it much, much harder to be the first to identify the ignored, hidden or misunderstood opportunities known as “value stocks,” which could return many times your investment. We are talking about the kinds of companies that Warren Buffett spotted about 50 years ago and that became the foundation of his $85 billion fortune — the big ones (Coca-Cola, Geico) and the small ones (Blue Chip Stamps, See’s Candies).
It wasn’t easy to find the potential behind these companies when Buffett was starting out. It’s more challenging now to find them ahead of the market, though the math geniuses, data dweebs and other assorted rocket scientists at hedge funds, private equity firms and asset management companies keep trying.
“As far as value stocks go, the market has gotten steadily more efficient over the past five decades,” said David Poppe, former chief executive of Ruane, Cunniff & Goldfarb, a 50-year-old investment firm that built its reputation on finding value stocks. Co-founder Bill Ruane was a close friend and colleague of Buffett’s, and the billionaire’s Berkshire Hathaway remains one of Ruane, Cunniff’s biggest holdings.
I have known Poppe, a journalist turned investor, for a few years and regularly attend the annual meeting of Ruane, Cunniff’s flagship Sequoia Fund. I have had a modest investment in Sequoia for more than two decades. Poppe is no longer with the firm.
I asked Poppe about the thesis of some investors that a value stock renaissance is coming after years of seeing prices lag behind the growth shares spearheaded by FAANG (Facebook, Apple, Amazon, Netflix and Google).
The information technology and communications services sectors contributed more than 70 percent of the S&P 500’s total return for July and 40 percent for the first seven months of 2019, according to Howard Silverblatt of S&P Dow Jones Indices.
In the 12 years from early 2007 to June 30, the Russell 1000 Value Index underperformed the Russell 1000 Growth Index by 136 percent, or by 4.3 percent annually, according to Chris Meredith of O’Shaughnessy Asset Management.
The Russell 1000 Value Index also trailed the overall Russell 1000 Index (growth and value stocks) from 2008 to 2018. The value index rose an average of 11.17 percent annually during those years. The Russell 1000 overall index averaged 13.27 percent a year, according to data from Research Affiliates.
A growing contingent on Wall Street believes that the exuberant prices powering growth stocks will eventually return to earth. The stock market’s leadership baton will then revert to the tried-and-true value stocks, especially the big banks and financial services, such as JPMorgan Chase, that were beaten down during the financial crisis. Morgan is known for its “battleship balance sheet” and strong management, led by chief executive Jamie Dimon.
“We think that it’s about time for value to rebound,” said Vitali Kalesnik, director of research in Europe for Research Affiliates. “Value looks very cheap compared to growth companies. We may be at a place where things can go in the other direction.”
The definition of a value stock has changed with the advances in investing. Where value once referred to stocks that traded at low prices relative to their earnings — with the emphasis on their being cheap — it now broadly encompasses the big, unglamorous U.S. companies whose stocks tend to be cheaper than those of their digital brethren, despite excellent fundamentals. Russell Value 1000 funds are led by Berkshire Hathaway, JPMorgan, ExxonMobil, Johnson & Johnson and Procter & Gamble.
“The whole idea of what constitutes a value stock has changed,” Poppe said. “A low-priced stock is not the same as a mispriced stock. In a fairly efficient market, low-priced stocks generally deserve their [low] multiples.”
His use of “multiples” refers to the ratio of a company’s stock price to its annual per-share earnings. The price-earnings ratio is a common way of measuring a stock’s performance.
For example, momentum stock Amazon (founded by The Washington Post’s owner, Jeff Bezos) has a PE of 78. Value stock JPMorgan has a price that is 12 times earnings.
Poppe likes both businesses, but he said many of the legacy companies disrupted by the digital revolution deserve their lower prices because they have been outpaced by the disrupters.
“A lot of what has happened in the last 12 years has been rational,” Poppe said. “The market for the most part has correctly seen that lots of these big Internet companies are extremely disruptive.”
Case in point: Procter & Gamble on Tuesday reported its best quarterly sales growth in a decade. But the 182-year-old consumer-goods giant also announced an $8 billion charge to write down its investment in Gillette shaving products. Gillette’s seemingly indestructible, high-margin business was disrupted by lower-priced, private-label upstarts such as Dollar Shave Club and Harry’s.
“Many low PE stocks today have their valuation because they can’t grow or don’t grow,” Poppe said.
Just look at IBM, a value stock with a strong dividend. Despite serial reinventions, IBM struggles to recapture historical dominance as the corporate world moves to the cloud. Even with its recent acquisition of Red Hat, it’s a value stock (PE ratio 15) for a reason: uncertain future competitiveness. Poppe notes that IBM’s revenue, profit and cash flow all have declined over the past five years.
“Value investing is about paying a low price for a future cash flow stream,” Kalesnik said. He said some hidden cash flows are right under your nose, like that of oil giant Royal Dutch Shell, which pays a big dividend and has rock-solid finances.
“Europe needs natural gas, and Royal Dutch Shell is perfectly positioned to increase natural gas supply from the North Sea to replace some of the gas Europe imports from Russia, for example,” Kalesnik said. “Shell is not priced with the same enthusiasm investors have in growth companies like [automaker] Tesla. People are looking for reasons to believe in Tesla. People are looking for reasons to discount Royal Dutch Shell.”
Value stocks can underperform for long periods, which makes it difficult for many investors who have clients with short-term horizons.
But not everyone. Some value investors spend months, if not years, engaged in close examination before investing in a company. That means digging deeper than numbers. It’s interviewing management, talking to customers, visiting the company.
“From time to time, a truly dominant franchise in a boring business or a lumpy business can trade for a lower PE multiple than the market overall, despite having excellent prospects,” Poppe said. “That’s when value investors need to act.”
Charles Schwab might qualify. It steadily builds market share by accumulating brokerage accounts and growing assets under management. But because it gets most of its income from interest margin spreads it earns on cash held for customers, low interest rates mask its competitive strength.
Right now, Schwab trades for 16 times earnings per share, less than the market overall, and those earnings are barely growing.
“To a value investor, it seems inevitable that Schwab will be much larger in 10 years than it is today,” Poppe said. “It’s underestimated.”
Poppe liked Schwab when he was at Ruane, Cunniff, and the firm still owns a stake. He also mentioned Progressive Corp., CarMax and TJX as businesses that have grown for many years and are very difficult to compete against but that historically have had modest PE multiples. (Perhaps because they’re in the unglamorous sectors of auto insurance, used-car sales and off-price retail, respectively.) They all ended up being winning investments for Sequoia.
I hesitate to say it (and, please, never take a stock tip from me), but Delta Air Lines could be another value stock. Airlines have been notoriously bad businesses for decades. Buffett once lamented his investment in USAir as one of his biggest mistakes.
But Buffett sees something in Delta. He is the airline’s largest shareholder, with 65.55 million shares worth nearly $4 billion, or about 10 percent of the company.
What does Buffett see?
One investor told me that Delta has a diversified revenue stream that includes a lucrative relationship with American Express that could double the airline’s credit-card-related revenue over the next four years. That makes Delta less vulnerable to a downturn in air traffic.
“A cheap stock doesn’t mean a lot anymore,” Poppe said. “But there are still cases where businesses are underestimated. A great business could be valued as if it is only good. Or a good business could be valued as if it is bad.”