What's Your Prior?

Irrationally Valuable

February 24, 2021 Damian Handzy Season 1 Episode 6
What's Your Prior?
Irrationally Valuable
Chapters
What's Your Prior?
Irrationally Valuable
Feb 24, 2021 Season 1 Episode 6
Damian Handzy

Markets can be irrational a long time, and we've been witnessing that over the past few years with Value stocks underperforming Growth and Tech stocks. But the tide may have turned, and Kate Mead is here to help us understand why Value is doing well and should do well over the next several years.

Mentioned in the Show:



Show Notes Transcript

Markets can be irrational a long time, and we've been witnessing that over the past few years with Value stocks underperforming Growth and Tech stocks. But the tide may have turned, and Kate Mead is here to help us understand why Value is doing well and should do well over the next several years.

Mentioned in the Show:



Damian Handzy:

John Maynard Keynes, the famed British economist whose work helped end the great depression learned his lesson in irrational markets the hard way -- by losing his shirt . Over a decade before his promotion of fiscal and monetary policy helped end that great depression and helped write his name in the history books, Keynes tried his hand at speculative currency trading. His broker loaned him 10 times his investment amount. He traded upwards of 40,000 pounds worth of currencies with an investment of only 4,000 pounds. Now, his economic research at the time led him to be rather bullish on the U S dollar compared to the European currencies. So, he started trading by betting on the greenback and against Franc, the Mark and the Lira . Within about six months, he had amassed profits of 14,000 pounds, but he soon learned that short-term trading based on long-term predictions was fraught with danger. Within about another two months, he was wiped out. His 14,000 pounds of profits turned into 13,000 pounds of losses, and he had to borrow about 5,000 pounds to pay off his debts. He summed up this experience with his now famous quote: "Markets can stay irrational longer than you can stay solvent. "

Intro Music:

Hello and welcome to What's Your Prior ? The podcast for the adaptable investor with your host , Damian Handzy.

Damian Handzy:

Value stocks have gotten a lot of negative publicity in the past few years, especially through the first eight months of 2020, largely because of how badly they've underperformed the broader market. And, in particular, how badly they've performed compared to Growth and tech stocks. Now, to be a value stock a ccompany's theoretical value has to be high compared to its market price. In other words, the market price has to be low compared to the theoretical value: the stock is undervalued. Now, through most of 2020 as value stocks' prices fell, they became even more undervalued . Now, one of my previous podcast, guests, David Asbell of Mount Lucas Management, he compared this phenomenon to a wound spring. With falling prices, value stocks' springs are getting loaded even more. But as Keynes painfully pointed out, markets can take their sweet time en route to their long-term prices. For the past several years, value investors have felt his pain, but the tide may have turned late last year. My colleague, Jim Monroe, and I, we dug into what kind of stocks will do well typically after us presidential elections. We wanted to know what kind of stocks do well after Republicans win and what kinds do well after Democrats win. Well, we were quite surprised to find that actually doesn't matter. In fact, value stocks are the ones that do really well after any presidential election, mainly because all presidents institute stimulatory policies that favor these under-priced value stocks. Now couple that this time with the COVID relief packages that are expected under a Democrat controlled legislature, it's no wonder that we've seen value stocks perform relatively well recently. Today's guest is Kate Mead, who's an expert in value investing. Hi, Kate , how are you?

Kate Mead:

Doing well, thanks, Damian. How are you?

Damian Handzy:

You know, getting through the winter, the days are getting longer. I think it's a minute and a half every day . I like it.

Kate Mead:

Yeah , me too.

Damian Handzy:

All right. Kate, can I just ask for a quick intro for our l isteners?

Kate Mead:

Sure. My name's Kate Mead . I work at MFS investment management and I've been at the firm since 1997. I started as an equity research analyst out of Wharton and covered a number of different industries. I transitioned into an institutional portfolio management role working on our value, us value and global value teams back in 2005 and have been doing that ever since.

Damian Handzy:

So let's get right into it. What do you think of equity markets over the past year?

Kate Mead:

You know, I think last year was a year that I don't think anybody would have predicted from a sort of a longer term active management perspective. Last year was a phenomenal year for active managers. There were a few things that kind of came together. You had many, many years of very limited volatility and anytime there's stress in the market and you see volatility increasing significantly, I think the average participant is generally pretty reactive and short-term oriented and that always provides great opportunities for those that are longer term focused in nature. I think because of the nature of the crisis that we were going through, even more important to be long-term focused. You know, 2020 was a total wash of a year. It doesn't matter that much because, you had these shutdowns that were put into place to stem the spread of the virus that had really significant impacts on lots and lots of businesses, but it's not indicative of the health of the business or the long-term fundamental picture. And I think at this point you really have to be looking out to probably 2023 to get to more of a normalized place. And so anyone that's not doing that I think is missing things. And that's a great opportunity for active managers to take advantage of that on behalf of our clients. There are absolutely great opportunities when you've got heightened volatility where uncertainty is high and where timeframe matters even more than it does in a normal environment. And I think 2020 had all of those things in spades.

Damian Handzy:

So Kate, 2020 really looked like the year for growth, right? Growth stocks really outperformed throughout most of the year - we saw a rotation back to value towards the end of the year, but through the course of the year growth really, really outperformed. But as I understand it, it's really concentrated growth, right? It's just the handful of large tech stocks, large high momentum tech stocks really were responsible for most of the gains of last year. How do you put that in perspective?

Kate Mead:

Was part of why you saw such a dramatic spread in the performance of the growth and value universes when you're looking sort of in a large cap space. I think the Russell 1000 growth finished about 36% ahead of the Russell 1000 value, which is the widest deviation we have ever seen going back to the creation of the indices back in 1979. And a lot of that came from those large tech companies who were sort of in the sweet spot of what was happening. You know, it was a market that there was a lot of exogenous events that were driving the performance of stocks. It was a market where valuation didn't matter the most expensive stocks, handily, outperformed the least expensive stocks, which is generally the opposite of what you see. And it's the opposite of what you see over the very long term . So the way that we invest is looking out three to five years or longer, and understanding the direction of travel, how companies are adding value, what are you paying for that? And making decisions based on those companies' specific attributes . And in an environment where the market is really, you know, can't see beyond the end of their nose and is reacting to short term data points and what's happening, it just creates an environment that sets us up incredibly well to add value for clients over the next two, three, four or five years, because the companies we're able to invest in based on maybe short-term headwinds that are transitional in nature are going to pay dividends over the longterm .

Damian Handzy:

So with that backdrop on 2020 and the increased volatility, the increased opportunity set for stock pickers and active managers to kind of do their thing, we also have stimulatory policy coming out of the government, right? W e've got $1.9 trillion ready to be signed and coming in. So is that why you're optimistic about value stocks because they do well in inflationary / stimulatory environments, whether or not interest rates go up anytime soon, they're kind of poised to do well with this new president and Congress, right?

Kate Mead:

So at a high level, I agree with your comments. I think in the face of declining interest rates have certainly been a benefit to long duration growth assets. And you've seen that. So I think that some of the valuation appreciation that we've seen in the growth companies and growth stocks has been understandable, given the decline in interest rates. Over time, with all of the stimulus, that's been already put into the system and we get another $1.9 trillion that's even more, is likely to be inflationary over some period of time. You know, you got the 10 year back above 1%. I think all else equal is going to be if you start getting inflation, creeping in, or people are worried about inflation, that will have a negative impact on higher multiple stocks. I think that's no question. When that happens - I have no idea. What I would say is, you know, I think in a rising rate environment, if you get a little bit of inflation back in the system, there are a lot of areas in the value, traditional value universe - financials being one of them -that should benefit. And I think it will have a negative impact on higher multiple stocks. So that as a backdrop should be more supportive of cheaper, multiple more value oriented companies. I'm personally not a believer in mean reversion. So if you say,

Damian Handzy:

Sorry, I have to cut in Kate just mentioned this concept of mean reversion. I think a bit of an explanation might be helpful. So mean reversion, It's just a fancy way of saying if the pendulum swings too far, one way it has to come back to the middle. Now it's also known as "regression to the mean," and it has its origins in late 1800's, genetics. Sir Francis Galton was the first person to observe that people with taller than average parents actually tend to be a bit shorter than their parents. And, people with shorter than average parents tend to be a little taller than their parents. In other words, that the height in offspring regresses back towards the average, towards the mean. Now his mathematical analysis led to the invention of linear regressions, which is a tool that is used, and I will say, often a-bused in many, many numerical analysis. Now, mean reversion is one of the most misunderstood and misinterpreted concepts in all of investing. It's subtle. And it applies to random variables that have stable averages. Now it's very easy to claim that mean reversion will cause some number to come back in line with where it's supposed to be, but mean reversion doesn't actually cause anything. It's more like an observed phenomenon than it is like a driving cause. Just like in basic statistics, when you flip a coin, right, let's say you get heads five times in a row. Does that mean that mean reversion will cause the coin to come up tails the next time? No, not at all. In fact, a true coin still has a 50 50 chance of coming up heads or tails on that next throw. Now is the coin "due" for a tail because it already came up heads five times in a row? Again, absolutely not. The very next flip is not affected by any of the previous five now. Okay, so, how does all this apply to value stocks? Well, I've heard many people that value stocks are due for a return, or that prices will return to the mean and fundamentals will matter again because of reversion to the mean. Now here's some of the problems with that line of reasoning. Uh , number one mean reversion does not operate on any set schedule. There is no " due". And you could be waiting a long time to see a historical return to average levels. Now historical averages can become stale, especially once more data's available or if market participants adapt to some new circumstance. Average is also can be moving targets. There's nothing that says that the average for the last decade should be the same as the average from this decade. Okay, now with all that background, let's get back to the conversation with Kate.

Kate Mead:

You know , optimism on all value. Uh , I wouldn't characterize my... -- That's not my perspective. I think there are companies for whom the pandemic has fundamentally altered their business in a way that it's not going to re --, it's not going to go back to what it was. I think there were secular challenges that were already happening that were meaningfully accelerated due to the pandemic. And those are businesses that are going to have to either figure it out or they're going to, they're going to be in real trouble. And so I don't think that you have everything sort of mean reverting, but I think there are a lot of companies that are trading - great companies - trading at reasonable evaluations that have the ability to compound returns over long periods of time and create tons of value that we own and that I would put into a value universe that I feel extraordinarily good about.

Damian Handzy:

Okay. So Kate, let's talk about how one actually goes about measuring the degree to which a given stock is a value stock. As you know, Style Analytics is all about measuring the sub factors for each stock and each portfolio. The traditional way to measure value established by Fama and French, back in the 90's, they used book-to-price ratio. Now we of course measure that, but we also provide over 20 different measures of "valueness." And last year we even wrote a paper about how free cashflow yield looks to provide a better measure of "valueness" than book-to-price, especially for modern companies, because it handles intangibles better. Now we don't advocate using any one measure, but rather always a number of them. And we certainly don't advocate using someone else's scripted formula. So each of our clients differentiates themselves based on their own way of evaluating each of these factors and in your case valueless. So how do you do it?

Kate Mead:

Yeah, so I think our process is one that tends to be pretty heavily cashflow focused primarily because that correlates extremely well with how companies create value over time. But we don't use one singular metric. We have a mosaic approach. We look at free cashflow multiples. We look at free cashflow yield. We do balance sheet adjusted valuation metrics. So, enterprise value to unlevered free cash flow. We look at normalized earnings and normalized free cash flow over time. We use DCF's [Discounted Cash Flows] and reverse DCF's as another tool to help triangulate not only what the potential opportunity is, but importantly, where can you expect to get downside support? So our investment philosophy has always been, if we do a really good job, not losing our client's money, where the rest is going to almost take care of itself. So thinking about those downside risks and scenarios is a really important part of our process, and valuation is a very critical piece of that downside support. I think that book-to-price or book valuation metrics have really been. I think we're , you know, historically where there's been a lot of emphasis, whether it's in the index construction, or more quantitative methodologies. And I think if you were to go back to the 1970s and probably to the mid eighties, that kind of made sense. A lot of businesses had hard assets, it was more manufacturing led and there was a greater degree of correlation between how companies created value and the book value - you know , book value and book value growth, and what you were paying for that. I think because of the growth in intangibles and intangibles today are about 85% of assets, that book value metric is less important across the board.