“We work really hard never to get confused with what we know from what we think or hope or wish.”
Value investing is often characterised as a bear market strategy. One of the persistant myths surrounding value investing is that while it may offer protection in down markets, returns will lag in good markets. A reason for this may be the perception that to invest in ‘value’, is to invest in weak, downtrodden, somewhat boring companies who were long-ago abandoned by investors. And while the share prices of these companies may be extremely attractive, they could remain extremely attractive for years. However, value is far more multi-faceted than this thinking suggests.
Value is about identifying a favourable relationship between price and future cash flows. While a steel mill selling at half the value of its assets might seem a good value stock, this is not necessarily the case. The best values are actually often found in the highest quality businesses which, for one reason or another, have seen their share prices fall. In the case of the steel mill, a sale or break-up could result in the hidden value in its assets emerging to the benefit of shareholders. However, barring that and assuming that its future results were weak (steel being a difficult business at the best of times), the share price would likely remain low. The quality business in contrast might well undergo a difficult year or two, but is still far likelier to see an improvement in its fortunes. With time, and growing cash flows, the value of such a company increases quickly. And markets usually don’t take long to mark-up share prices when business improves. For a value investor bull markets are not a bad time. In fact, with the benefit of low prices paid when companies were undergoing setbacks, they can be very profitable as these stakes are suddenly re-valued.
Value investing is a much more all-weather philosophy than many credit it for. Where value investors cringe, is from the ‘momentum’-driven market, such as we experienced in the late 1990’s. This is the market where the traditional warning “past performance provides no guarantee for the future”, seemingly becomes “past performance is a guide to future performance”. Stocks rise for no apparent reason other than that they rose the day before. In such an environment, the value investor’s focus on company fundamentals and low prices can be unrewarding. Luckily, however, these periods usually end with a bang!