“Fear Pays A Premium”: Why Investors Overlook The Most Unloved Stocks At Their Peril

“Fear Pays A Premium”: Why Investors Overlook The Most Unloved Stocks At Their Peril
Andrew Rummer

over 2 years ago10 mins

This is a transcript of an interview with Research Affiliates' Vitali Kalesnik. To listen to the podcast, tap the 🎧 button above.

When you’re investing in stocks, it makes intuitive sense to look to those that are currently cheap. After all, who doesn’t love a bargain? 

There’s one major catch with that approach, however. Since the aftermath of the 2008 financial crisis, buying these cheaper so-called “value” stocks has proved a consistently losing strategy. Instead those who’ve bought the most expensive stocks – known as “growth” stocks – have beaten the market over the past decade or so. 

The consistent outperformance of those glamorous growth stocks over their dowdy value cousins has helped make the careers of growth-focused stock pickers like Ark Investment Management’s Cathie Wood. And made those who focus on value stocks eat helping after helping of humble pie. 

But, over the past year or so, there have finally been some signs of life in the value part of the market. And our guest on Insights today – Vitali Kalesnik of the investment firm Research Affiliates – is here to make the case that value stocks’ time in the sun is only just beginning. 

Vitali began by explaining to Finimize analyst Andrew Rummer why he believes value stocks are such a great place to invest at the moment. 

Vitali Kalesnik: So value stocks, by definition, are cheaper than growth stocks. And if we're to take the last 50 or so years of history, that average discount of value companies to growth companies is about one-to-five.

Now what we've seen over the last decade, ending last summer, is that during the decade, that relative valuation went from a somewhat expensive point – so it wasn't one-to-five it was actually closer to a one-to-three discount, so value was relatively expensive a decade ago – and then it went to extreme valuation difference. So at the bottom of the Covid fears last summer, I think value companies were trading at a one-to-11, one-to-12 discount, depending how you were to look at it. And that's when value was extremely cheap. So as value stocks relative to growth stocks were becoming cheaper and cheaper on a relative basis. That was the key driver explaining the underperformance. And so what it meant then is that not only was so the outperformance that we've seen late last year, early this year for value versus growth, it was not just the result of somewhat declining fears over Covid but it was the extreme discount that value companies were traded at. And so the market just jumped on the opportunity, as long as it showed up just not being extremely risky to them. 

And so why we think that that run-up is not over, is because that discount is still quite extreme. In fact, today that discount is still wider than it was at the height of the tech bubble. And as a researcher in finance, much of my career has been post-tech bubble. And I would think I would never see that relative valuation ever in front of me. And here we go today, the value companies are cheaper than growth companies by the margin than they were at the height of the tech bubble.

Value equity is probably the only asset class that is likely to deliver in the next decade or so, a return which is on the order of 5%-plus per annum ahead of inflation. And so today's a unique opportunity to invest into these companies.

Andrew Rummer: When I observe the behaviour of smaller investors, when they start buying stocks a lot of them immediately seek out companies working on the latest new technology. Those that are trying to solve some tricky problem that has the potential to change the world – and they want to get in on the ground floor. It sounds that you're not attracted to that as a method of picking stocks. So what's wrong with that approach?

Vitali: The short answer is: price matters. It's not like we are opposed to buying great growth companies. Probably the definition and approach to value that most appeals to me is the traditional approach, pioneered by Graham and Dodd in the 1930s. And that approach said that the way to invest is to compare the intrinsic value of the company – where you take the company's value in terms of its future cash flows plus current assets – and then you compare it to what the company is currently traded at. So if market value is lower than intrinsic value, that’s a great buy. You buy the company in the market, you're getting this future stream of cash flows, which will far exceed what you're paying. And vice versa, if a company is overpriced – the market value is much larger than what it's worth – then maybe it's a candidate for a shorting or just avoiding. So look at how much you're paying for this great company. And it's not like you should avoid buying great companies: great companies can be great investments, and that exponential growth can more than justify what you're paying for it. So as long as the market value is less than that what the growth can justify, you're still doing value investing. 

I guess sometimes value investors have been portrayed as you're just buying things that are going to die, and that's risky and silly. And of course it is. I couldn't agree more. Value investing is not buying junk that is going to sink and that is potentially overpriced relative to what these companies are. Value is buying companies – sometimes it could be distressed companies and risky companies, but if these distressed companies and risky companies have solid business models, they have solid cash flows, and you can buy them at low valuations, well, that's great. If everyone else is scared of it, then more than likely you are likely to earn a premium. Because fear pays a premium. 

Andrew: Following on from that, another trend among some of the new investors that have flocked to the stock market since the pandemic is that they seem to appreciate the entertainment value of investing. And plenty of them find it more fun to think of their money fueling some insurgent creating future technology that’s going to make everyone's lives better than to think that they’re just milking steady dividends from some boring blue chip incumbent? Is there an issue here where value investing suffers from being perceived as boring in the current environment? 

Vitali: Is value boring? Well, I don't know. I'm not sure that it's just buying the old boring companies. For example, what are some of the value examples today? Well, it's energy. Yes, energy is an old traditional industry, but is energy important? Yes, it is. Unless we expect to go into the dark ages and have no heat and no entertainment. That's what it means for us not to have energy. And how are we going to get energy for the next 10 years? Well, of course, there are many new technologies appearing and wind power and solar power are becoming steadily more important. But for the next 10 years, most of the energy will still be obtained in the same way as today. And if by buying these companies today at low prices, you can participate in providing heat to yourself and providing entertainment to yourself. 

I've talked about the tech bubble and the tech bubble was a period of great valuations. And many may not remember, but it also had a lot of entertainment value. There were these huge waves of IPOs and these very lavish IPO parties. And after IPOs, many of these companies continued their run-ups. And so, yeah, that was their entertainment value there. That was entertainment value for a few years, until it all stopped as the market corrected. So beware of that too: entertainment can stop at some point.

Andrew: Is there just a shorthand to all of this that if there's a lot of buzz around a certain stock, then maybe think twice before investing? Does it come down to something that simple?

Vitali: Yes. So think twice, look at the price, then. Yeah, and do some research.

Andrew: And I guess you might conclude that it's still a good investment, but just be extra wary, I suppose. 

Vitali: Absolutely. 

Andrew: So if people listening to this buy your argument that there's still further to run in this value part of the stock market, how can they invest? What's the best way to start screening for these kind of value stocks?

Vitali: So some of the segments that are probably a cheaper price than others are – well, actually, the UK market is quite attractively priced on an absolute value level. Emerging markets are quite cheaply priced. And so are European markets by the way, they also tend to be priced on the cheaper side. Whereas, for example, the US market – when we're comparing various countries – is priced quite expensively. So look at these cheaper regions for opportunities and also look at the type of sectors that are perhaps scary for investors to hold right now. And so what are some of the scary sectors? Well, financials, energy, for example. Financials and energy are the types of sectors that get hit hard during recessions. And so it's not such a surprise that they got hit hard last year. We remember last year that oil prices were hitting negative levels, and so it’s not surprising that the energy sector got a strong hit in terms of valuations. But today, these sectors – financials and energy – are looking quite attractive. They’re cheap. 

Andrew: It's easy nowadays to find loads of exchange traded funds that are labelled as value. What do you think of these value ETFs?

Vitali: Pay attention to what is under the hood. Price-to-book is probably one of the most popular ways to define value. That's a common definition common in academia and many funds are using price-to-book to define value. I'm not a big fan of it. The one big problem with book value as a discount for price is that it tends to miss intangibles, which in the current environment tend to misclassify many modern companies as too expensive. The truth is that book value is just not very good at capturing the true capital of the company. Let me explain a little bit what the issue is. The book value of equity is an accounting term which computes the initially contributed capital plus retained earnings. But then, interestingly, if you spend your capital buying a building, that value of the building – a fixed asset – will stay on your book value as a positive amount. So you just put it from one pocket to another but it still stays in your book value. If, on the other hand, you were to invest it into R&D, software development, or run an ad campaign, all of that is treated by traditional accounting as a cost and therefore it's out of your book value. But who would run R&D unless it's an investment? Probably no one. And so from that point of view, book value can miss a lot of the capital for modern companies. And because of that recently, we've seen it performing worse compared to other measures. So, basically, look for measures diversified across regions, companies, but also look for measures that are not just based on price-to-book but look at price-to-cash-flows, for example, price-to-sales, price-to-dividends.



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