Hedge funds broadly continued their rotation from growth to value stocks during the fourth quarter, as was apparent from an analysis of 13F filings. The months- or years-long rotation (depending on whom you listen to) has been a stark reminder of the long-running competition between growth and value investors.
In fact, the outperformance of growth over value caused some value investors to throw in the towel, like AJO Partners, which called it quits in 2020, citing the extended “drought in value.”
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John Bader’s value investing masquerading as growth
However, many of the value investors who stayed in the market approached the long-lasting drought by tweaking their definition of value investing instead of abandoning the strategy entirely.
In some cases, these adjustments were made rather quietly. For example, John Bader of Halycon Asset Management told attendees at a Project Punch Card Conference a few years ago that Benjamin Graham-style value investing didn’t work anymore. Specifically, he said buying statistically cheap securities didn’t the market at that time, although it could work in other markets.
Bader adjusted his definition of value investing, mixing in some elements typically found under the quality and growth factors. In addition to looking for cheaper stocks, he also looks for firms with outstanding management teams, competitive advantages and strong growth prospects.
Sounding an awful lot like a growth investor, Bader said he was seeking companies that were likely to continue compounding their earnings while reinvesting their business instead of statistically inexpensive companies.
Mixing in quality and growth
Similarly, Dan Kaskawits and John Mullins of Lyrical Asset Management have been mixing in other factors with value. Specifically, they look for factors that typically describe companies that fall into the quality and growth buckets.
In an email, the Lyrical team explain that they have always valued companies based on their five-year forward earnings. They said their portfolio is “cheap on traditional metrics” at around 11 times forward P/E, but their focus on long-term earnings enables them to “avoid the many low-quality businesses captured by the value factor.”
Lyrical buys the cheapest stocks based on their five-year forward earnings and avoids slow-growers with hopes of mean reversion in favor of value. The fund buys compounders that Kaskawits and Mullins expect to deliver significant free cash flow over the seven to eight years they typically hold each stock.
“Many low P/E stocks have flat or declining earnings,” the Lyrical team said in an email. “… Businesses with low P/E’s, but with flat or declining earnings are not cheap; they are expensive. This is why we are highly selective within the cheapest quintile of stocks, seeking to only buy simple-to-understand, high-quality and growing businesses.”
Seth Klarman widens his definition of value investing
Another legendary value investor who has adjusted his definition of value investing is Seth Klarman of Baupost. In his year-end letter for 2021, Klarman says that while they remain value investors “to the core,” their definition of the term differs from what business schools typical teach today.
Traditionally, value stocks are those with low P/E multiples, low price-to-cash-flow multiples, and low price-to-book-value multiples. However, Klarman pointed out that low-multiple stocks can fail to provide value if the underlying business is dying, a turnaround is unlikely, and management is “squandering cash.”
His definition of value stocks includes any stock whose current price is significantly lower than the company’s underlying value, whether it is growing or not. The Baupost chief looks for “mispricings,” which can occur for a variety of reasons, like complex situations, short-term disappointments, and investor neglect.
In fact, Klarman can even find value in the stock of a company with reliable growth that trades at a fairly high multiple based on current results “and a materially low multiple a few years out if (and this is a big ‘if’) the expected growth actually materializes and is sustained.” However, he added that there is risk inherent in high-multiple stocks.
If their earnings falter, their stock could plunge as growth investors exit rapidly, creating a mispricing in a high-growth company and opportunities for value investors such as Baupost.
Joel Greenblatt and Warren Buffett on value investing
Greenblatt, another legendary value investor, agrees that the widely held definition of value was what was wrong with it rather than value investing in general. In an interview with ValueWalk last year, he said Morningstar’s and Russell’s definitions of value haven’t worked in more than 10 years.
Greenblatt also defines value investing differently than them, choosing instead to define it as trying to “figure out what a business is worth and pay less.” He looks at expectations for cash flow growth over time rather than low price-to-book value.
Greenblatt also pointed to something Warren Buffett said decades ago, which was that growth and value are “tied at the hip.”
“Growth is a part of valuation, so that’s our definition of value, so it should never go out of favor,” Greenblatt said.
In his 1992 letter to Berkshire Hathaway
“What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” he wrote. Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation.”
A closer look at the value indices
Many value investors started to look for alternate definitions of value investing because major value indices made it appear as if it was broken. Kaskawits and Mullins point out that the EAFE Value Index has been underperforming for so long that they are often asked if value investing is broken.
They note that between the end of 2016 and the end of 2021, the EAFE Value Index has underperformed the EAFE by 28 percentage points. Additionally, the Value Index underperformed the EAFE in 11 of the last 15 years.
“The value index may be broken, but value investing is not,” the Lyrical team explained. “If you look at the performance of the cheapest stocks in the non-U.S. developed markets, instead of looking at the performance of the MSCI EAFE Value Index, you see a very different picture emerge.”
Indeed, a look at the various value indices reveals continuing underperformance of value despite all the signs that hedge funds and other investors have been rotating into value. For example, the S&P 500 Value Index is down by about 3% year to date, although it’s up by 12% over the last 12 months.
However, the entire S&P 500 is up by a little over 12% over the last 12 months, so the value index didn’t beat the broader market despite that supposed value rotation. The MSCI World Value Index gained 22.8% in 2021, compared to the MSCI World’s 22.35% gain.
A value rotation without outperformance
Thus, the Lyrical team’s approach to value investing highlights how the rotation to value is occurring even though the indices are not capturing the outperformance in value. Kaskawits and Mullins pointed out that the cheapest quintile of stocks — as measured by five-year forward P/Es — has outperformed the MSCI EAFE Value in 10 of the past 15 years.
“Our cheapest quintile outperforms the EAFE Value because it reflects the cheapest companies base don long-term earnings power,” they wrote. “A value investor wants to minimize future cashflows for the cheapest price possible, and our valuation quintiles therefore sort based on five-year forward P/Es.”
The Lyrical team adds that MSCI favors companies with low levels of growth when it constructs its value index. They explained that MSCI assigns each constituent in the EAFE Index a value score and a growth score, and stocks with high value scores and low growth scores are placed in the value index.
On the other hand, stocks with high growth scores and low value stores are placed in the growth index. Meanwhile, stocks with high value and growth are diluted within the indices.
Confusing the indices
“These are some of the best opportunities and where we spend most of our time sourcing ideas — cheap stocks with high growth,” the Lyrical team emphasized. “But, to MSCI, these stocks confuse the algorithm, so they are included in both the Value and Growth indices at partial weights, diluting their influence.”
The Lyrical team pointed out that 2021 was an excellent year for value stocks, but again, the value indices couldn’t keep up. The EAFE Value lagged the cheapest quintile of stocks by 360 basis points.
“Consider that the EAFE Value has only managed to keep its earnings flat from 2007 through 2022 estimates,” the Lyrical team noted. “That’s 15 years without any growth.”
Source: https://www.forbes.com/sites/jacobwolinsky/2022/03/21/forget-benjamin-graham-these-legendary-investors-have-changed-their-definitions-of-value-investing/