5 minutes reading time
This post begins with one of the funniest FinTwit quotes I’ve ever seen. It’s funny because its witty and it contains a fair amount of truth. The tweet highlights the fact that many value stocks have limited growth potential. Many operate in challenged or distressed industries. They are often not the kinds of businesses that you want to own long-term.
The returns to value investing are heavily reliant on finding differences between intrinsic value and price that close in a reasonable period of time. This creates some anxiety about when to sell.
What if the gap between estimated intrinsic value and market price never closes? What if it takes too long to close? What if the underlying business continues to deteriorate?
These are valid questions. Remember:
- The distribution of value stock returns suggests that a value stock is statistically more likely to be a loser.
- The key to success as a value investor is to a) capture the few big winners that drive the value premium, b) pick “the best of the worst” or c) some combination of the two strategies
- Investors MUST capture some of the big winners otherwise they don’t earn the value premium.
- One or two big losers is all it takes to derail the performance of a value strategy even if a manager is a skilled stock picker.
- Value investors must buy stocks trading at prices significantly below their estimate of intrinsic value. In other words, they need to look for a margin of safety.
- A margin of safety erodes over time. It must be realised within 2-3 years.
Value Investing Requires Trading
Imagine that an investor wants to earn a long-term compound return of 9% per annum. Company X, has a share price of $10 and it trades at a dividend yield of 5%. Because its a value stock, it’s earnings growth rate is likely to be below the long-term average for the S&P 500 of around 6%. Let’s say it’s 3%.
A 5% dividend yield + 3% earnings growth = 8% total return. The only way for investors in Company A to earn a 9% return is if they buy shares at a discount to intrinsic value.
Let’s assume they do this and that the discount closes over a reasonable period of time. Once the shares reach Company’s A intrinsic value (assuming it hasn’t increased) our investor again earns an 8% return.
The only way for our investors to keep earning a 9% return is to sell their shares in Company A and try to find another stock trading at a discount to intrinsic value.
The success of a value investing strategy depends on being able to find a steady stream of stocks trading at a discount to intrinsic value.
There’s also the reinvestment of dividends to consider. Company X pays a 5% dividend, but how should it be invested? Is it possible to find another stock to invest in that will match the target rate of return? If not, the annual rate of return of portfolio will decline over time.
Logically, it follows that the long-term performance of a value strategy depends on being able to find enough cheap stocks in the FUTURE. This is what is meant by reinvestment risk. We’ll come back to this idea a little later on in this post.
Value investors must usually sell stocks within 2-3 year of purchase for one of five reasons:
- The spread between price and intrinsic value has closed (winner)
- There are better opportunities elsewhere
- The margin if safety hasn’t closed and is being eroded over time (loser)
- The share price continues to fall and it looks like the company’s situation might result in bankruptcy
- Intrinsic value doesn’t increase over time
The last reason, the lack of growth in intrinsic value, is worth elaborating on a little further.
Intrinsic Value – Going Nowhere Fast
Value investors do not have the luxury of being buy and hold investors. Why? Because most value stocks have poor future growth prospects. After all, it’s usually the reason why they’re cheap!
Yes, the market may over-react, punishing stocks that disappoint and creating opportunities for value investors. But that doesn’t mean that the market’s assessment of future growth is wrong.
Research indicates that the market is actually quite good at identifying which companies have the potential to grow their earnings faster. In their paper Clairvoyant Value and Value Effect Rob Arnott, Feifei Li and Katrina Sherrerd found that:
Growth stocks (those trading at high multiples) do historically exhibit superior future growth, the market overpays for superior growth expectations with statistical significance.
Growth stocks underperform because investors over-pay for growth, not because they are incapable of identifying which stocks have better growth prospects. The market is usually correct in forecasting that most value stocks will struggle to grow their earnings over time.
In other words, the intrinsic value of most value stocks is unlikely to grow very much over time. This is consistent with the distribution of value stock returns. In contrast, a growth stock (if chosen correctly and bought at a reasonable price) can make a wonderful buy and hold investment as its intrinsic value continues to grows over time. This is what Warren Buffett meant when he said:
Time is the friend of the wonderful company, the enemy of the mediocre.
Let’s compare two stocks, a Value and a Growth stock:
- Price = $10.00
- Earnings per share (EPS) = $1.00
- P/E ratio = 10x
- Dividend payout ratio (DPR) = 0.60
- Long-term EPSg = 5% per year
- Assume valuation remains constant
- Total return = 11% (6% dividend yield + 5% EPSg)
- Price = $10
- Earnings per share (EPS) = $0.50
- P/E ratio = 20x
- Dividend payout ratio (DPR) = 0.10
- Long-term EPSg = 10% per year
- Assume valuation remains constant
- Total return = 11% (1% dividend yield + 10% EPSg)
Both stocks have the same expected total return of 11% per annum. The Value stock trades on a P/E ratio of 10, half the P/E ratio of the Growth stock. Which would you buy?
The Value stock offers an attractive combination of a 5% yield and a reasonable growth rate. The duration of the Value stock’s cash flows is relatively short, making the Value stock less volatile over the short-term.
But the Value stock is vulnerable to future levels of stock prices, which are impossible to predict.
Remember, the 6% dividend yield needs to be reinvested!
The greater the dividend yield, the more dependent the investor’s total return will be on future stock prices.
Over a 14 year time horizon, the Value stock investor must reinvest dividends totalling $18.06. That’s equal to the initial purchase price, the growth in dividends per share and the dividends received on invested capital combined!
This ignores taxes. Paying tax on dividends would reduce the amount available for reinvestment. It would also significantly reduce the long-term return from holding the Value stock.
In contrast, an investor in the Growth stock only has to reinvest $3.01 in dividends over 14 years. Long-term stock price fluctuations are far less important to an investor holding the Growth Stock. And the smaller dividend payment mean taxes also take a smaller bite out of returns.
This is not to say that the Growth Stock is without risk. The reduced reinvestment risk of the Growth stock comes at the expense of higher volatility in the short-term. A revenue or earnings miss and the stock gets clobbered. An increase in cost of capital, either through higher interest rates or a higher equity risk premium, and the stock gets clobbered. And you’re relying on company management to invest retained earnings wisely. If the don’t, you guessed it, eventally the stock gets clobbered.
The aim of this post isn’t to argue that growth investing is better than value investing or vice versa. Both strategies have their opportunities and their challenges. Rather the aim is to highlight the trade-off that value and growth investors make:
- Value – less volatility in the short-term, greater need to trade, higher taxes due to a larger proportion of returns coming from income and lots of reinvestment risk in the long-term.
- Growth – more volatility in the short-term, possibility of holding for the long-term, lower taxes due to a smaller share of returns coming from income and very little long-term reinvestment risk.
Each of these risks is not static. For example, there are good reasons to believe that the reinvestment risk of value strategies is currently at a very high level. You’ll have to wait until part seven “When cheap isn’t cheap” to find out why.
Other posts in this series:
- Value Investing – Don’t get Skewered!
- Losers in the Driver’s Seat
- Margin of Safety – the Clock’s Ticking
- Reinvestment risk – Got any ideas?
- Growth – the Enemy of Value Stocks
- When cheap isn’t cheap
- Hitting the target
- We liked it at $10, so we like it even more at $7
- Value Investing – Some Suggestions