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Successful investment management can be Impaired by perverse incentives, which are what now plagues value funds.
When researching potential investments, we often must choose between math and facts versus irrational human behavior. For instance, the rise of passive investment strategies has many investors favoring “value” stocks not on valuations or earnings trends but on self-serving Wall Street classifications. As a result, larger companies that meet vague categorizations attract more passive dollars. This makes them even more prominent and value-like, and further inflates their valuations.
For investors willing to do some work, this circular pattern leaves excellent value stocks in the wake of the behemoth passive value investment liner.
In the words of value investing legend Benjamin Graham:
The true investor will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
As Graham stated, value investing is not a popularity contest. It involves picking stocks that trade at cheap valuations and pay dividends. Despite his wisdom, value investing has morphed into buying the largest companies simply because they are labeled "value" by the banks and brokers that are heavily incentivized to grow their asset base on which they earn fees.
To help appreciate the warped investment world, I present two stocks.
Blind taste test
To appreciate what truly is versus what is considered value, I give you a blind investment scenario. Please choose between stocks A and B.
Stock A is significantly more expensive than B using popular traditional valuation metrics. Stock B is growing its sales and revenues much faster than A. In fact, sales at A have declined slightly over the last 10 years.
Before deciding, think about the question in another light. If you were investing in a private business, which would you choose?
Nearly 100% of you armed with that limited information would opt for stock B.
I provide one more piece of data. Stock A has a market cap of nearly $350 billion, 27 times that of stock B. Does that sway your decision?
Sadly, that makes all the difference for unknowing passive investors.
Analyzing A and B
Stock A is Proctor & Gamble (PG). The consumer staples company was founded in Cincinnati, Ohio, nearly 200 years ago. PG sells a wide range of well-known consumer products globally. Its top products include Tide, Pampers, Bounty, Gillette, Crest, and a slew of other brands you are likely familiar with.
Stock B is Stanley Black & Decker. The household and industrial tool company was founded in Connecticut and is nearly as old as PG. Like P&G, some of its products are well-known by households globally. It also makes industrial tools that may be less familiar. Some of its most popular product lines include DEWALT, Black and Decker, Craftsman, and Cub Cadet.
Before comparing valuations, it's worth evaluating their revenue and earnings growth over the past 10 years. The trend lines help smooth out quarterly gyrations and highlight prevailing trends.
Revenues at SWK have risen 5.4% annually over the last 10 years. The growth has been remarkably predictable. On the other hand, PG experienced a -0.53% annualized decline in revenue over the period. Since 2015 it began trending higher at a 3% annualized rate, still moderately below SWK's growth rate.
Evaluating earnings per share (EPS) tells a similar story. P&G has increased its EPS by 2.5% annually. Such compares poorly to SWK's 6.7% annualized growth rate.
More telling, PG has repurchased almost 15% of its shares over the 10 years. SWK has only repurchased 4% of its shares. PG's EPS over the period would be close to flat without buybacks.
PG versus SWK valuation
Revenue and EPS growth are important metrics, but they do not tell whether the stock price represents value. To take the next step, it is vital to compare fundamental valuations, or how much it costs investors to buy a stream of future sales and earnings. The table below shows seven popular valuation methods. In all cases, SWK is hands down significantly cheaper.
Based on my analysis, a value fund should greatly prefer SWK over PG. Further, many of PG's ratios are more expensive than the S&P 500. However, what a value fund should desire and what it owns are often two different things.
Vanguard's Value Index Fund ETF (VTV) has a market cap of $66 billion. It owns over 2% of PG and only 0.07% of SWK.
The well-followed iShares S&P 500 Value ETF (IVE) has a market cap of $21 billion. The fund holds 0.96% of PG and only 0.08% of SWK.
The story is the same for dividend-centric funds. SWK has a 3.73% dividend yield, about 1.25% more than PG. Despite the larger dividend, two of the more popular dividend ETFs, VYM and VIG, allocate 2.5% and 3.00% to PG, respectively. VYM does not hold SWK, and VIG only holds 0.09% of its assets in SWK.
For value funds to grow, they need securities with ample shares that can be bought without grossly affecting the price (i.e., liquidity). The ETF and mutual fund business models financially reward the fund manager for the fund size, not how well they live up to their stated objective. To grow, many value funds stretch the meaning of "value" to increase the universe of acceptable stocks. Often broader definitions of value result in stocks like PG, which may be stable and conservative companies but do not trade at value-like valuations.
Any rational investor staring at valuations and fundamentals would likely choose SWK over PG. Any rational investor gauging where investor dollars flow would choose PG over SWK.
And that is the crazy environment in which we find ourselves. If passive strategies continue to dominate, stocks like PG may continue to outperform stocks like SWK, despite valuations and earnings and revenue growth. However, stocks like SWK offer an increasingly greater value proposition as the trend continues.
In an unstable market, as we may be approaching, SWK and other true value stocks may provide a port in the storm, leaving PG and others vulnerable to selling if the passive investment crowd has a change of heart.
Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.
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