Something of Value

During a recent interview, a famous investor questioned whether value investing will ever return. With all the ways to invest these days, it seems like value investors are few and far between. Quant shops use machines to parse data. Passive exchange-traded funds track benchmarks. Top-down shops invest based on their assessment of macro-driven trends. Fewer investors care about the fundamental value of a company, which includes the worth of its assets and future cash flow streams. As a result, this famous investor argues, there are dislocations in the markets because nobody pays attention to what a company is actually worth.

We agree dislocations exist. Fewer people are making investment decisions based on carefully researched, fundamental valuations. We disagree that this means value investing may never return. Those who know how to properly value a company may be better poised to unearth opportunity before the rest of the market detects it, since there are now fewer folks who invest based on fundamental analysis.

What lies beneath

Markets have changed significantly since Mutual Series started focusing on value stocks in the late 1940s. There are fewer dedicated, fundamentally driven value managers. The markets themselves also look different. Machines running quantitatively managed active and passive strategies make up an increasing portion of the equity markets. Many of these programs classify stocks based on ratios such as price-to-sales (p/s), price-to-book (p/b) or price-to-earnings (p/e), which are pulled from a company’s financial statements.

Mechanical value investing driven purely by low p/e, low p/b and simple reversion to the mean has underperformed for over a decade. Pricing differentials among value companies have widened, with organizations that invest in their own technology and research and development infrastructure outperforming their peers. It is difficult to identify these companies simply by ratio analysis and mean reversion. However, analysis of future growth prospects, free cash flow generation, competitive positioning, and catalysts for corporate evolution can identify companies potentially poised for outperformance. Since it can take a while for these slow-moving waters to carve a better company, screens used by non-fundamental investors may not immediately register the effects.