Compelling Value

by | Jun 20, 2019 | Investing, Long-Term Edge, Trading Edges

Executive Summary

  • Asset classes trading significantly below intrinsic value occur infrequently, perhaps once every 10-20 years per asset class. We need to accept that asset pricing (for long hold periods) is rational and correct most the time, and that cheap asset classes are usually cheap for a reason.
  • I discuss methods I use to determine when an asset class is irrationally mispriced well below long-term intrinsic value. I’m trying to distinguish a once-a-decade compelling valuation versus run-of-the-mill everyday value opportunities. Compelling values set up lucrative multi-year trades to the long side.
  • While there’s no formula for identifying these opportunities, I present three steps I take in the search. First, I find prices that appear to be an extreme outlier with respect to history, logic and other asset class valuations. Second, I identify the behavioral effect causing the asset class to be mispriced compared to long-term intrinsic value. Finally, I ask myself a few common-sense questions, such as: If I was designing a portfolio to hold for the next 10 years, would I substantially overweight this asset class?
  • A compelling value is a trading edge that’s long-term in nature, so an asset class can stay that way for years. Since it’s unknown when (or if) the market will recognize a compelling value, an asset class trader ultimately requires a timing catalyst to initiate the trade. Getting the timing basically right – for a move that can take years to unfold – is an important edge for the asset class trader compared to value investors and asset allocators.

Introduction

Value investors typically hold cheap securities based on an analysis of future growth prospects and many valuation measures. They sell assets that rise in price (and hit price targets) and replenish the portfolio with cheaper assets that have recently suffered price drops. They manage the portfolio with a low turnover, typically 25% per year or lower. Many securities purchased may be underpriced due to irrational overreactions to bad news, but most are likely cheap for a reason – they are riskier or have inferior growth rates. This is particularly true for the value screens used by index-based value ETFs.

Contrary to adopting the value investor philosophy, as an asset class trader, I’m only interested in using the value approach when there’s a compelling opportunity. A compelling value at the asset class level is created by irrational human behaviors working on very long time scales to drive a price well below intrinsic value. Examples of such behaviors include long-term investor herding, industry-wide groupthink, gun-shy investors fearing a repeat of severe losses, and bubbles.

Sorting out what’s cheap and expensive among various asset classes is inherently difficult because asset classes have vastly different risk and return characteristics. It’s hard to compare Russian stocks with U.S. stocks because there are significant non-quantifiable risk differences. How can we estimate when growth stocks are underpriced? When do high-yield bonds have a better risk-adjusted expected return than equities? These questions are impossible to answer definitively.

Despite the difficulties, an educated guess that an asset class is undervalued, combined with a catalyst, can be a huge source of outperformance. In this blog post, I attempt to distinguish a once-a-decade compelling valuation created by long-term, irrational human logic and the “good values” we read about in research reports every day.

When human behavioral effects are long-term in nature, they’re difficult to arbitrage away since the aberrations they cause only happen about once a generation. Irrational behavior on short- and intermediate-term time scales can be systematically exploited by hedge funds, portfolio managers and traders. Effects such as momentum and short-term reversals are behavioral in nature and ultimately fail to add value due to overuse.

Long-term compelling value opportunities manifest differently each time. Developing an investment thesis requires creativity, experience, open-mindedness and a contrarian view. There’s no formula, and it seems most investors and traders lack the innate skill to identify such opportunities – a skill that Howard Marks calls second-level thinking.1

We can also view a compelling value opportunity as a long-term variant perception as introduced by the highly successful hedge fund manager Michael Steinhardt.2 Steinhardt defined a variant perception as a well-founded view that is meaningfully different from market consensus. Steinhardt’s focus on applying this concept was aimed at short- and intermediate-term trading opportunities, but the same logic applies to what we’re trying to do on a long time scale.

Since it’s impossible to fully backtest strategies associated with this trading edge, I take the approach I use to develop skills associated with identifying motivated buying and selling opportunities. Carefully document each thesis, put the trade on, keep track of results and use the feedback to get better at it.

Below are three guidelines for identifying compelling values. First, I discuss the use of valuation metrics to identify outliers. Next, I discuss the need to identify the behavioral forces pushing prices below intrinsic value. The final guideline is using common sense to round out our assessment of the value opportunity. We ultimately need a catalyst to initiate an actual trade, but that will be the subject of the next blog post.

Guideline #1: Identify valuation extremes and outliers

Figure 1 shows the Shiller CAPE valuation measure for the S&P 500, discussed at length in the previous blog post. In that post, we concluded that price is most often an excellent measure of intrinsic value for hold periods associated with value investing (5-10 years).

But that’s not always the case. So where on this chart did human emotions and behavioral induced logic errors most likely cause prices to diverge from long-term intrinsic value? It’s most likely, but not always, at the extremes. As asset class traders, it makes sense to wait for extremes before using the valuation trading edge.

Figure 1: S&P 500 Shiller Cyclically Adjusted Price-to-Earnings (CAPE) Ratio (from this website). Latest number as of May 21, 2019. Data previous to 1881 uses smoothed earnings from 1871 up to that date.

We can immediately point out the peaks in 1929 and 1999, which were associated with FOMO-based stock market bubbles. The current CAPE ratio of 29+ also seems to be at extreme levels, which I discuss later. The low points in CAPE history (occurring in 1877, 1921, 1932, the 1940s and the 1980s) were all moments of heightened investment risk and uncertainty. On these dates, prices may have been irrationally too cheap, and they certainly were great moments to buy stocks.

The low points in the 1870s, 1921 and 1932 were all associated with depressions. At the 1932 low, the Dow Jones Industrial Average was trading at a dividend yield of 15% and a price/book of 0.7. U.S. stocks in the early 1980s traded below book value, had a dividend yield of 6% and a CAPE below 10. Of course, inflation was the issue in the early 80s, yet equities are also a great long-term inflation hedge.

Figure 2 shows the U.S. high-yield bond spread going back to the early-1980s when these securities first became an asset class. Most the time during the past 40 years, junk bond spreads likely accounted for all risks and competing asset returns, and thus offered no compelling value opportunity. Only at the extremes were prices likely mispriced and behavioral factors at play. The rising yield spreads in the early 1990s were likely pushed to extremes by perpetual selling by savings and loan banks struggling with a recession that ramped up defaults in their high yield bond portfolios. During the 2008-2009 financial crisis, forced selling by hedge funds was certainly in play. Perhaps at these two moments, prices offered compelling values. There are probably a few other points in Figure 2 when junk bonds were too cheap versus other asset classes, but that’s hard to know looking at the chart.

Figure 2: U.S. high-yield bond spreads (versus U.S. treasury yields) since 1983. Copyright 2019 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

How do we sort through all this noise? It takes experience and skill, but generally if the asset class appears undervalued from all angles, then that’s a start. The more indicators showing an extreme value, the better, although we need to ensure that charts are not cherry-picked or using indicators that are stale or losing relevance. I don’t like charts with short time histories (fewer than 40 years), unless they can be anchored with valuations going back further in history.

Waiting for extremes helps provide a buffer for the large uncertainty associated with valuing an asset class. I remember looking at all sorts of value indicators in the depths of the 2008-2009 financial crisis to make the case that the S&P 500 was a compelling value. Even at the lows, the CAPE was just mid-range compared to history (see Figure 1). At the time, it was a mixed bag, with some value indicators suggesting the S&P 500 was a compelling opportunity, but others not. However, when I looked at various spread product asset classes, such as high-yield bonds and bank loans, all indicators were at extreme levels, which looked much more attractive to me at the time.

Right now, the U.S. stock market appears to be trading at extreme values based on many measures. U.S. growth stocks have significantly outperformed over the past decade, while value stocks have lagged. Emerging market (EM) stock indices associated with countries such as Russia, Korea and Turkey all trade near book value; but of course, these markets are fundamentally riskier.

Below, I show a few more asset class valuation charts that have perked our interest over the past year.

Figure 3 shows a forward price-to-earnings ratio associated with the long-running T. Rowe Price New Horizons Fund. This Fund, which invests in U.S. small- and mid-cap growth stocks, has been a huge winner the past 10 years (as of March 31, 2019), with an annual return of 22.1% per year, compared to 15.9% per year for the S&P 500. This chart indicates that small/mid cap growth equities are trading at extremes much like during the Go-Go era of the late 1960s and the internet bubble era of the late 1990s. These days, the theme revolves around U.S. tech disruption, the Silicon Valley unicorn factory, and U.S. equity dominance in general. While there are various opinions of when (or if) this current trend will end, no one can question whether this valuation measure is at an extreme.

Figure 3: T. Rowe Price New Horizons (Symbol: PRNHX) forward looking price-to-earnings ratios. From the Annual Report dated December 31, 2018.

Figure 4 shows a very different situation – the ratio of platinum to gold near all-time lows. Platinum has many “store-of-value” properties that are like gold. Platinum is an inert precious metal used in jewelry and coinage and is 10 times rarer than gold. Platinum also has many industrial uses, primarily in diesel engine catalytic converters. In this sense, platinum is a “dual-use” precious metal, much like palladium and silver.

Palladium, which is used in gasoline engine catalytic converters, has skyrocketed in price due to shortage worries. Palladium now trades at an extreme premium versus platinum, as shown in Figure 5. There have also been some rumblings about car manufacturers switching from palladium to platinum to save costs. Both charts suggest that platinum is possibly a compelling valuation because it’s being ignored as both a store-of-value and as an industrial metal.

Figure 4: The price of gold, platinum and the gold/platinum ratio (as of May 20, 2019). Copyright 2019 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

Figure 5: The price of palladium, platinum and the palladium/platinum ratio (as of May 20, 2019). Copyright 2019 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

Figure 6 shows a premium/discount chart for the Nuveen NY AMT Free Quality Municipal Bond Closed-End Fund (Symbol: NRK). This chart represents most single-state muni funds trading on the NYSE. At the end of 2018 this fund (and many others) traded at a discount to net asset value of about 16%, which was higher than at any time except the 2008-2009 bear market. Not only was the discount extreme, the tax-equivalent yield for a New Yorker was north of 9% per year. Investors were obviously concerned about the Fed raising rates and the impact of Trump’s new tax package. Combined with tax-loss selling at the end of the year, the compelling valuation made this asset class a strong buy. Since then, the fund is up 13.5% YTD as of May 21, 2019, and still appears to be an excellent value and diversifier versus equities.

Figure 6: Premium/discount chart of the Nuveen NY AMT Free Quality Municipal Bond Closed-End Fund (Symbol: NRK). From www.cefconnect.com.

Another essential angle in searching for outliers is to compare forward-looking estimates of risk-adjusted returns among all asset classes. Many research organizations estimate future returns for asset classes. Each has its own methodologies, and asset class traders should develop a sense for how to do this. The best source I know is the awesome Asset Allocation Interactive Tool developed by Research Affiliates, shown below in Figure 7.

Figure 7. Expected real returns for asset classes over the next 10 years (as of April 30, 2019). Asset Allocation Interactive Tool developed by Research Affiliates.

Figure 7 indicates real expected returns in the 5-7% range for international and EM stocks over the next 10 years. These expected returns are not that compelling, although they’re highly attractive compared to bond yields and U.S. stocks priced to deliver a real return of 0-2% per year. Along with the historical charts shown in Figures 1 and 3 above, international and EM stocks appear to be a compelling value, at least versus U.S. stocks. Research Affiliates is also predicting that EM currencies will provide attractive future risk-adjusted returns.

Table 1 below shows a comparison of valuation multiples for a variety of equity ETFs that represent stocks from around the world. The top section shows four funds that represent the winners over the last decade – U.S. stocks, and specifically, U.S. growth stocks. The section below that shows a sampling of four international developed equity markets, all with companies that have been long-term powerhouses in manufacturing, consumer goods and finance. Germany, Japan and the U.K. are also on par with the U.S. with respect to rule of law and property rights.

European and Japanese equity markets have lagged U.S. stocks for many reasons, including poor demographics, anemic economic growth, Brexit, and much less tech-sector exposure compared to the U.S. stock market. International market valuation multiples have contracted significantly compared to U.S. stocks over the past decade.

Table 1: Valuation multiples for a variety of world market ETFs. Data from Morningstar.

The section below that shows four ETFs tracking EM indices, which are subject to additional risks, including corruption and a lackluster record on property rights. Valuation multiples trade at significant discounts, yet everyone agrees these markets have higher growth rates and better demographics than developed markets. Valuations are much cheaper than those associated with U.S. stocks.

The final two ETFs, representing EM value and international value, have the lowest multiples and seem to represent the polar opposite of U.S. large-cap growth stocks. GMO, another asset class allocator, suggests that value stocks are now trading at discounts to growth stocks not seen since the late 1990s.4

Professional stock pickers have many rational explanations for the wide difference in multiples. First, they claim that stocks around the world have been priced to equate future risk-adjusted returns, and thus multiple differences can be explained by the sector makeup of each country’s stock index. The United States has many more growth companies that make up the S&P 500. International and EM markets have more exposure to cyclical and traditional industries, and thus logically trade at a discount. Valuation measures, such as price-to-book, price-to-sales and dividend yield, are now viewed as indicators that are losing relevance in a world where intellectual property is highly valued, and companies prefer buybacks to dividends. Value stocks may also have more debt than growth companies, which is unattractive late-cycle and with interest rates expected to go up over the next decade.

Perhaps one last measure of compelling value is when respected and highly successful value investors are also buying. Most value investors select individual securities, but is there a broader asset class theme in what they are buying? What are the Asset class thought leaders buying? Currently Warren Buffett is buying large, U.S. money-center banks trading near book value. Value managers are motivated to tell others what they own since they want the market to recognize value as soon as possible.

Guideline #2: Why is the asset class an excellent value?

It’s not enough to have valuations at extreme levels. Michael Steinhardt states that when you’re developing an informed variant perception, it’s important to have a keen sense of what’s priced into the market. We seek opportunities when extreme valuations are the result of long-term, irrational human logic or non-economic forces, such as long-term government policies.

In the next section, I discuss several situations where compelling values can be created by long-term forces and human behavioral flaws. Without such an explanation, or hopefully multiple irrational forces in play, an extreme valuation is not compelling.

Risk-Off Bear Market

Bear markets often create mispricing on the short, intermediate and long time scales. Stocks and high-yield bond prices fall significantly in this environment, often due to forced selling and excessive fear of loss. Economies are dipping into recession and the news flow is largely negative. We can expect irrational pricing (bargains) in this environment. For example, during the 2008-2009 bear market, closed-end funds holding cheap high-yielding bonds traded at significant discounts (~40%) to their net asset values in the depths of the downturn.

Most investors sense that buying at these moments will produce attractive investment returns, if an investor can simply ignore the short-term volatility and paper losses and hold for the next 10 years. Yet, buying is just too scary for most people to do.

Bear markets can also serve as a catalyst for long-term relative performance trends to reverse. When the highfliers finally fall back to earth, investors may prefer a long-languishing, underpriced asset class that has gone from cheap to compelling value during the downturn.

Government Price Manipulation

Central banks and government officials commonly manipulate prices to suit the needs of their country and to remain in power. This is not a behavioral effect, but such actions can create mispriced asset classes for decades and large moves once price controls are lifted. From the mid-1930s to the late 1960s, gold was fixed at $35 an ounce in the United States. Gold became very undervalued, especially as inflation ramped higher throughout the world in the late 1960s. When gold was floated versus the dollar in 1970, a 10-year bull market ensued.

Government manipulation can also create expensive asset classes. Currently, central banks in many countries have forced interest rates into negative territory, something that’s never occurred in history. This monetary policy has created all sorts of asset pricing distortions. Long bonds issued by European and Japanese governments yielding 0% look extremely overvalued and uninteresting.

Governments pegging currencies, controlling commodity prices, buying stocks and banning short selling are all examples of actions that distort prices from intrinsic value, which may lead to a trading opportunity when a policy is reversed.

Unending Period of Negative Flows and Divestitures

Imagine an asset class that was the star performer during a prior decade and peaked a few years ago. It’s overowned, and at the margin, investors are giving up on the asset class. The process is expected to weigh on asset prices for years. If there’s an endless supply of price-insensitive sellers, market participants may hesitate to step in front of the selling wave and prices may fall below intrinsic value and stay there for many years. One example of this effect was the perpetual selling of U.S. growth stocks from 2004-2009 by individual investors caught up in the internet bubble of the late 1990s.

Perhaps the sellers are shifting to a hot, bubbly asset class, such as when value stocks were sold to rotate into technology and growth stocks in the late 1990s. Banks, governments and various industries may be engaged in a long period of divestitures, creating lots of supply. An example of this activity was central banks selling gold in the 1990s and 2000s.

Novelty Premium Associated with a New Asset Class

New asset classes are often priced at a discount to what they’ll eventually trade at over time. The asset class is new and underowned. Investors need an incentive to explore and perform the due diligence required to make an investment. There’s no price history to gain a sense of value. Examples of this effect include the introduction of U.S. government-issued TIPs in the late 1990s, Build America Bonds in 2009, catastrophe bonds in the mid-1990s, and the introduction of various fintech platform securities in the early-2010s. The introduction of bitcoin and cryptocurrencies 10 years ago is another example, but I could never make a case for that asset class during its spectacular rise.

A Long Period of Underperformance

After a long period of underperformance, such as 10 years or more, the likelihood of price diverging from long-term intrinsic value increases. Few investors have an interest in owning an asset class that’s been a loser for so long. Raising money to invest in this space is a fruitless endeavor. Freshly minted MBAs have no interest in establishing a career related to the asset class. There’s often no catalyst for a change on the horizon. Perhaps a few value investors are looking for treasure among the slim pickings, but investor attention is elsewhere.

Just because an asset class has performed poorly for many years doesn’t mean it’s a compelling value. Apathetic investor holdouts and zealots typically hang on for decades, which may create an anchoring effect that delays price from falling to intrinsic value – much like homeowners who refuse to sell their home for a price below what they paid for it.

I like scanning asset classes for the worst 10-year performers to find these sorts of opportunities. Current examples of such asset classes include gold mining stocks and agriculture futures. Many collectibles eventually sit in this space during their post-bubble years. The past 10 years have been highly favorable to U.S. growth and technology stocks. Meanwhile, international, EM and value stocks have all underperformed for years.

Investors Fearing a Repeat of Previous Painful Losses

After experiencing painful losses, investors typically hesitate to invest in great values. Such a “once-bitten, twice-shy” effect for investors or career-risk-mitigating CYA activities among institutions can occur with all asset classes. Investors (both individual and professional) nursing heavy losses from a previous cycle have no appetite to get involved again (at least initially).

This effect can keep an asset class trading below IV for quite some time, even after years of attractive performance. U.S. stock valuations in the late 1940s and early 1950s were undoubtably held down by a generation of investors impacted by the great depression and world wars. Famed value investor Ben Graham’s risk tolerance was permanently affected by losses associated with the Great Depression.5

After two large bear markets associated with the internet bubble (2000-2002) and the Great Recession (2008-2009), institutional investors never regained their excitement for public equities, preferring to divest into alternatives such as private equity, hedge funds, real estate and liquid alternatives.

More Sanguine View of Risks 

When a segment of the market is suffering a crisis, and investors are selling to reduce severe short- and intermediate-term risk exposure, then perhaps there’s an opportunity to pick up an asset that’s a good long-term value. For instance, if an upcoming event is keeping professionals with a short-term view away from an opportunity, then perhaps price will fall below long-term intrinsic value. U.S. health care stocks often trade lower leading into elections. Currently, worries about Trump tweet risk and tariffs are perhaps keeping a lid on Chinese equity prices.

Another example is buying airline stocks after the 911 terrorist event in September 2001 on the view that air travel is not going away. Perhaps Mall REITs offer long-term value because investors are underestimating the ability of mall owners to repurpose their properties as they’ve always done in the past. There are many examples of these moments, and it’s often difficult to judge whether a price drop is a rational repricing of risks or a large overreaction to near-term fears. A short-term panicky sell-off based on bad news or capitulating redemptions, combined with excellent long-term value measures, may be a good catalyst for investment.

Another Asset Class is Attracting All the Capital

A bubble in one asset class can suck capital and attention away from others, creating irrationally underpriced asset classes. Value stocks, REITs, long-term treasuries, and commodities in the late 1990s are examples of this effect. When the bubble finally bursts, it serves as a catalyst for these neglected value opportunities to have their day. The Nifty-50 phenomenon in the early 1970s is another example, and perhaps current investor fascination with U.S. growth stocks also fits this sort of behavior.

Any time an excellent value is associated with a true shortage of capital investing in the space, then there’s an opportunity. When banks step away from lending to real estate investors, it’s reasonable to assume that real estate prices may fall below intrinsic value. During the U.S. housing bust of 2006-2012, the amount of bank capital to buy homes fell dramatically because of tighter lending standards, upside down mortgages and mortgage defaulters losing access to credit.

Investors Ignoring History and Long-Term Cycles

History, economies and industries all tend to move in long-term cycles. The economic fundamentals associated with these cycles, which can lead to material changes in asset class valuations, also ebb and flow. Periods of high growth are followed by low-growth periods. Competition causes margins and returns to mean revert. High prices tend to lead to low prices. High returns attract capital, fame and fortune. Investors lose interest in low returns. Creative destruction and new technologies ultimately cause older companies and industries to die.

When these cycles go on for a long time, an investor groupthink can set in that rationalizes asset class valuations and assumes the cycle will go on forever. Career risk mitigation, investor myopia and investor inexperience can all create this effect. New generations of investors enter the game with naive views on opportunities and with few battle scars. Going against the current megatrend and buying an excellently valued, ignored asset class is very difficult to do professionally. It’s as if the markets have mispriced the optionality that at some point the cycle will change. Billionaire investor Howard Marks has recently released a book discussing how to take advantage of these various market cycle dynamics.6

Horrible-to-Bad Trade

When an asset class appears obscenely cheap due to extreme turmoil and future risks, then perhaps there’s an opportunity even if prices are rational. For example, after Putin invaded Crimea in 2014, Russian stocks traded at 70% of book value and five times earnings. Currently European and Japanese banks trade at 50% book value, deep-sea drillers trade at 33% book value, many Mall REITs and the Turkish stock market trade below book value.

When an individual stock is priced this way, then it’s probably heading to bankruptcy, or it’s due for a dividend cut or a massive secondary equity offering. But entire stock markets don’t go bankrupt and most sectors don’t either. The motivations and incentives of all players are for asset prices to recover.

The idea behind this setup is that we can earn very attractive returns when the situation goes from horrible to just bad. It’s a concept from GMO portfolio manager Arjun Divecha, who says, “One of my favorite sayings is that you make more money when things go from truly awful to merely bad than when they go from good to great.”7

Guideline #3: Common sense assessment

Does the price of an asset class make sense given the current risks faced and centuries of market history? Sometimes taking a mental step back and applying common sense can point to relative and absolute valuation anomalies.

For instance, at various moments since the great financial crisis, sovereign bonds issued by European peripheral countries, such as Italy, Greece and Spain, have traded at yields below U.S. treasuries, even though no one believes they’re a better credit risk than U.S. bonds. Another example is negative-yielding bonds. While there may be short-term trades and arbitrage opportunities associated with owning these bonds, common sense suggests that over the long term, we don’t want to touch European and Japanese sovereign bonds at yields hovering around 0%. There are trillions of dollars of value tied up in these bonds that can simply be avoided using common sense.

Here are some common-sense questions to help assess a compelling value opportunity:

  1. If you had to design a portfolio of asset classes to be held for the next 10 years, would you substantially overweight the undervalued asset class?
  2. Compelling absolute valuations are much easier to grasp than compelling relative values. For equity asset classes, an expected return that is 1.5-2x better than the historical 5-6% per year net of inflation should be considered compelling. For safe government bonds, the hurdle rate is a real return of 1-2% per year. Other asset classes can be gauged with these historical rates of return in mind.
  3. Can you easily explain the compelling value, or does it take an intricate trail of logic and a 100-page research report to assess the risks and prove the point?
  4. When there’s blood in the streets, and it seems that stocks will never go up again, can you simply be optimistic? Can you rely on the knowledge that the world population, earnings, productivity and GDP will grow over time? Can you rely on the view that rising asset prices is aligned with everyone’s best interest? How about the view that the world is trending toward being a better place?
  5. When using a historical chart, are circumstances worse than they were at previous instances when a valuation measure was so extreme? The world’s stock markets have survived an enormous number and variety of calamities. It’s quite possible that what is currently being experienced is not as bad as then.

In the mid-1980s, stock-picker extraordinaire Peter Lynch purchased 30-year Treasuries yielding 15%.8 Common sense suggested this was a great deal, especially when mixed with U.S. stocks. By comparison at the time, equities historically delivered 10% per year and long-term treasuries had produced about 3% per year. Of course, inflation was raging in the 10-15% range, so an investment in long-term treasuries may have seemed reckless back then. Ultimately the investment worked because inflation eventually cooled and trended lower for the next three decades, and 30-year bonds outperformed stocks with only a weak correlation to equity returns.

As a final example, we can illustrate the compelling value opportunity associated with U.S. home prices near the bottom that developed in 2012. Figure 8 shows that aggregate U.S. home prices peaked in 2006 and fell 34% over the next six years, triggering the bank crisis of 2008-2009. Prices fell much more in many sun-belt cities, such as Las Vegas and Phoenix.

Throughout the bottoming process that started in 2010, housing prices drifted lower, even as 30-year mortgage rates fell below 4%, housing affordability metrics blew through previous highs, and with the stock market signaling that the U.S. economy was on reasonable footing. REITs and homebuilders bottomed with the stock market in March 2009 and had steadily marched higher throughout the 2010-2012 period. Housing starts fell to lows not seen since World War II, while future household formation was ever growing. Many homeowners were stuck in their current homes due to underwater mortgages, or they defaulted, which took them out of the market to buy another home. Small-time home investors were wiped out along with hard moneylenders that financed fix and flip trades.

Figure 8. S&P/Case-Shiller 20-City Composite Home Price Index (from https://fred.stlouisfed.org/series/SPCS20RSA)

Back of the envelop calculations showed buying a home and renting it out could produce very attractive returns in the 15-20% range. In February 2012, Warren Buffett appeared on CNBC and stated, “If I had a way of buying a couple hundred thousand single-family homes I would load up on them.”9 That’s indeed what a few private equity firms did, even as some questioned whether a portfolio of single-family homes could be managed economically.

At this time, any investment related to U.S. housing was excellent.10 The long six-year bear market had taken out many potential home buyers. There was a severe lack of capital to invest in this space.

Non-agency mortgage backed securities (NAMBS) were producing yields in the 15-20% range with what appeared to be plenty of collateral to avoid principal losses. Jeffrey Gundlach of DoubleLine funds wasn’t shy at the time about describing these opportunities, and funds he managed produced enhanced, risk-adjusted returns in future years. A closed-end fund loaded with these securities, the TCW Strategic Income Fund (Symbol: TSI), produced total returns of 22%/year between 2010 and 2012.

For illiquid investments, such as purchasing an apartment building, you essentially have to use a value approach, since hold times are long and there’s no ability to trade in and out of the asset class. Class-B and C apartment buildings also bottomed in the same time frame, offering very attractive future returns.

Since bottoming in 2012, the Case Shiller 20-City Composite Home Price Index has risen by 6.6% per year over the past 7 years to a new high. The CoStar U.S. Commercial Property Equal-Weighted Index (as a proxy for Class B and C real estate) has about doubled to a new high (9.8% per year). With leverage, these assets produced extremely attractive returns. Many of the irrational pricing issues described above applied to housing back then.

Conclusions

The focus of this blog post is the search for mispriced asset classes associated with long multiyear holding periods, which is the time scale of value investing. Judging whether an asset class is a compelling value takes experience, years of practice and likely a natural knack for that sort of work. It can be humbling.

There are so many significant issues with using value to select future outperforming asset classes, a trader acting on short-to-intermediate time scales may want to ignore value completely. A self-aware trader might just state up front that “value investing is not my game, so I’m going to ignore it.”

This is not a bad game plan, but I’d recommend working on these skills over time so when a compelling value presents itself, an asset class trader can capitalize on the opportunity. Also, the asset class trader can use trading tools to help nail the moment to pounce on the trade, which is an advantage over value investors that must leg into these investments over time without a catalyst.

At other moments, buying illiquid private investments may be extremely attractive, and since the hold time is naturally 5-10 years, an asset class trader has no choice but to assess the opportunity with a value approach and “buying right.”

When assessing a compelling value, we need to see valuation measures at extremes with respect to history and to be an outlier compared to other asset-class risk-adjusted expected returns. We also need to identify a human behavioral effect that has pushed prices to these extremes.

Currently, international and EM stocks appear to be a compelling value compared to U.S. stocks. It’s interesting that in the absolute sense, international and EM stocks are priced to deliver returns in-line with history, while U.S. stocks appear to be highly overvalued. Perhaps a significant bear market is needed to shift international and EM stocks from the “relative cheap zone” to compelling value territory. Value stocks around the world, which continue to underperform the market and U.S. growth stocks, also appear to be a compelling value in the making.

 

 

References

  1. Marks, H., The Most Important Thing: Uncommon Sense for the Thoughtful Investor, 2011.
  2. Steinhardt, M. No Bull: My Life In and Out of Markets, 2001.
  3. Rowe Price New Horizons Annual Report, December 31, 2018.
  4. Friedman, R. “Value Investing: Bruised by 1000 Cuts”, GMO Research Report, May 2019.
  5. https://novelinvestor.com/rise-fall-rise-ben-graham/
  6. Marks, H., Mastering the Market Cycle: Getting the Odds on Your Side, 2018.
  7. Strauss, L.C., “The Four Cheapest Plays in Emerging Markets”, Barron’s, July 27, 2009. (https://www.barrons.com/articles/SB124847504858080139?tesla=y)
  8. Lynch, P., One Up On Wall Street: How to Use What You Already Know to Make Money in the Market, 2000.
  9. https://www.heatondainard.com/warren-buffet-says-buy-buy-buy/
  10. Marks, H., Mastering the Market Cycle: Getting the Odds on Your Side, 2018, Chapter XI.

 

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