Advisers can leverage a tough year for value stocks as an entry point into equities with a higher margin of safety than the market.
A repeat performance of the 2008 stock-market debacle again failed to materialize in 2012, as U.S. equities outperformed most asset classes despite a global economy wracked by tumult. Can-kicking and bond-haircuts have supplanted soccer as the most popular pastime in Europe; debt-laden Japan engages in outright monetization of its obligations; and emerging and developed nations alike wrestle with slow-growth, slowdowns, and recessions. Amidst the din, U.S. stocks have defied the chorus of “Profit margins are too high! Unemployment is too high! Valuations are stretched!” What's going on and how can investment advisers benefit?
There are two lasting truths to the equity markets. One, the obvious, is volatility. Equities are more volatile than bonds. This works in both positive and negative directions, but as losses bring more pain than gains bring joy, the downside is burned into the long-term memory of investors. The other investing fact is stock prices are backed by actual businesses. There is a living entity behind the flashing green and red stock prices, backed by employees, brand-names, cash-flows, and other oft-ignored tangible buttresses that only show up in long-time horizons. As GDP numbers stagnate, debt burdens hinder governments, and stock prices zoom upwards, one only needs to go behind the scenes and view the global dominance of U.S. companies to understand why profits continue to increase. Of course, hindsight is a thunderous advantage — what about next year and beyond? Are there still U.S. companies growing profits and out-maneuvering competitors without commanding high valuations? The answer is a hearty yes!
Within the heavily publicized bull and bear market cycles lives constant tug-of-war between value and growth stocks. Value stocks are driven more by actual cash-flows rather than optimistic future projections, and therefore are less prone to deeply disappointing investors with “lower-than-expected” forecasts. In fact, value stocks are often value stocks because the disappointment is already reflected in the stock price. These valuations are like a spring — the more they are compressed, the more pent-up energy to drive future gains. The market, driven by human nature, tends to overshoot in both directions. Growth and momentum stocks drove 2012 stock market performance and have probably come too far too fast, while the Value Spring has become extremely compact and is now ready to pop.
An adviser screening for businesses trading at low Enterprise Value / EBITDA valuations coupled with high returns on capital might be confused. Was there really a great 2012 for stock prices? Many stocks in this “quality value” category are down 20%, 30%, even 50% YTD. Research will find companies in this bucket are often strong competitors, shareholder friendly, and able to generate cash in tough economic environments. Finding a solid business trading at a low EV/EBITDA multiple should soothe the mind of any volatility-minded investor but what solace can these prices offer the truly skittish? Essential services like healthcare and business IT fit these criteria, and in the 2008 financial crisis these companies' profits ignored the U.S. recession and continued to march ever higher. There is significant disparity in valuations, unlike the heady days of 2007 where correlation was high and valuations between the high and low-priced stocks were similar. Today, an adviser can find a solid grower producing a significant amount of free cash flow trading 50% lower than the market average, while simultaneously unearthing businesses producing little to no free cash flow commanding valuations 50% higher than average. This is a recipe for a delicious value portfolio with stock-picking as the icing on the cake. Ingredients contributing to this potential outperformance are made possible by another 2012 trend — massive flow toward exchange traded fund products.
While advisers fleeing equities have partially contributed to disappearing yields in fixed income, those who have remained in stocks are more and more using ETFs to index client money at low rates. This has rightfully taken money away from mutual funds that are “closet indexers,” but it has also created the aforementioned great opportunity in value stocks due to a lack of stock-picking. Less desirable sectors are punished as a whole, even if they contain standout companies increasing profits while suffering from valuation compression.
In a year where macro-worries bubbled over, the best-performing stocks seem to be the most worrisome. High fliers are built on stories, but as Apple has shown, even the best stories have a price limit. Rather than roll client money into what has worked in the past, investing in solid businesses before the flows arrive is a superior alternative. Value stocks can attract attention even without the majority of investors piling in — as private equity funds, larger businesses, and other strategic buyers can ramp up acquisitions of these unloved but healthy firms.
Brian Frank is the president of Frank Capital Partners LLC (FCP) and the portfolio manager of the Frank Value Fund since inception in June of 2003 and July of 2004 respectively.
