Why These ‘Hated’ Stocks Are About To Have Their Day
Most investors instinctively know that value stocks are generally less expensive relative to earnings and book value. They are typically mature, well-established businesses that can afford to distribute more of their profits as dividends. Common examples include drug maker Pfizer (NYSE: PFE), consumer products giant Johnson & Johnson (NYSE: JNJ), and wireless provider AT&T (NYSE: T).
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By contrast, growth stocks are companies that typically reinvest most of their earnings back into the business, so there is often little (if any) left on the table for dividends.
Wherever the dividing line falls, investors have shown a clear preference for growth. But smart money naturally flows into pockets with optimal risk-adjusted potential rewards. So it’s rare for one group to stay at the top (or bottom) for more than a few years.
The last time value stocks were this hated was the late 1990s. I remember it well, because I was a financial advisor trying to convince clients to allocate a portion of their portfolio to equity income funds, but all they wanted to hear about were exciting growth funds.
#-ad_banner-#And why not? S&P 500 growth stocks delivered sizzling returns of 42% in 1998 and 28% in 1999, while value stocks were underwater. Guess what happened the following year? They changed places, with the underpriced Russell 2000 Value rebounding to a gain of 23% and the overpriced S&P Growth giving back 22%.
This is a common occurrence. Emerging market stocks enjoyed a long run at the top of the ten major asset classes between 2003 and 2007, before sinking to the bottom in 2008. Likewise, investment-grade bonds were bottom of the barrel in 2009 and 2010, before shooting to the top in 2011.
But this persistent dominance of growth over value has been going on for a decade now (ever since we came out of the 2008 recession).
Growth stocks are teetering at 28 times earnings and 5.8 times book value. Meanwhile, value stocks can be bought for 19 times earnings and just 2.1 times book value. Arguably, a stronger growth trajectory merits a richer price — but premiums this wide are hard to ignore. Even without a market scare, it’s time for value stocks to step back into the spotlight.
Value Stocks: Not What You Think
There is a misconception that this group is old, stodgy and boring. To that, I would say that Warren Buffett has done okay with mundane businesses such as banks, insurers and railroads.
But Buffett, the biggest practitioner of value investing (he won’t invest a cent in a business unless it’s trading at a sufficient discount to its fair value) has also made huge bets on new economy stocks such as Apple (Nasdaq: AAPL) and Sirius XM (Nasdaq: SIRI). These are not your stereotypical value stocks. But the lines are sometimes blurred, because growth is a component of value.
All things equal, the more cash a business can churn out tomorrow, the more it’s worth today. So rapidly expanding companies can justifiably carry higher valuations than peers and still be underpriced.
In fact, that was the secret behind famed money manager Bill Miller’s legendary streak. They say that most mutual fund managers can’t beat the market over the long haul. Well, Miller’s Legg Mason Value Trust did just that for an impressive 15 years in a row.
That streak was finally broken in 2006, but not before he turned a $10,000 investment at inception in April 1982 into $395,000 — about $156,000 more than a broad index fund would have returned.
You may recognize the name. But here’s what you might not know: Miller achieved stardom by taking large stakes in companies like eBay (Nasdaq: EBAY), Google (Nasdaq: GOOG), and Amazon.com (Nasdaq: AMZN) — highfliers that value purists wouldn’t touch.
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That’s because Bill Miller and Warren Buffett see value through a different prism. They evaluate qualitative (i.e. economic moats) and quantitative factors to calculate a firm’s intrinsic value. The backbone of that calculation projects future cash flows and then discounts those earnings back to today’s dollars.
This is far more comprehensive than simply using today’s earnings as a yardstick (especially knowing they can be inflated by asset sales, deflated by one-time charges, and distorted in other ways). Plus, today is just a brief snapshot in time.
The point is, growth and value aren’t separated by an invisible velvet rope. And farsighted money managers can spot opportunity where others can’t.
How I’m Scooping Up Value Right Now
I just recently told my High-Yield Investing subscribers about a an income fund that’s run by one of the best money managers on the planet. This outfit has racked up average returns of 14.8% over the past decade — besting not only the growth-oriented S&P 500, but also 99% of its value peers. And thanks to Mr. Market’s sour mood recently, the yield has just broken through the 6% level.
I can’t chare the name of this pick with you right now, but I would highly recommend defensive-minded investors look for quality value-oriented funds to add to their portfolio. It’ll not only provide some diversification — but if I’m right, then value stocks will have their day in the sun soon enough.
In the meantime, if you’d like to get the name of this pick — as well as learn how to access to my entire High-Yield Investing portfolio — simply go here.