Why Do Value Investors Do Poorly?
It is the emotional nonprofessional investor who sends the price of a stock up or down in sharp, sporadic and more or less short-lived spurts. The professional investor has no choice but to sit by quietly while the mob has its day, until the enthusiasm or the panic of the speculators and nonprofessionals have been spent.” –J. Paul Getty
Can You Explain This?
Starting on page 4, this money manager explains his firms consistent underperformance. Do you agree or disagree? Why? A lesson for investors.
Wedgewood View 3rd Quarter 2016 Client Letter (Start on page 4)
Has the Outperformance of Indexation Run Its Course During This Cycle?
Our performance struggles versus our benchmark and the S&P 500 continued during the quarter. 2016 is on course to be one of the worst years for active managers over the course of the last two market cycles. Aside from this, we have noted (lamented?) in recent Client Letters, as well as in client meetings and client calls, our frustration (surely our clients’ frustration, too) that while our portfolio’s collective fundamentals (sales, earnings, cash flow, and book value) continue to grow in line—if not exceed—the same benchmark measures, our portfolio’s valuation has not kept pace with the valuation increase in our benchmark. The same applies to the S&P 500 Index as well. The net effect over the past few years is that our portfolio simply (and yes, frustratingly) gets cheaper still from the already discounted relative benchmark valuation.
The table below compares four fundamental growth metrics between our mutual fund, the RiverPark/Wedgewood Fund, our benchmark fund, the Vanguard Russell 1000 Growth Fund, plus the stock market, as represented by the Vanguard 500 Index Fund.
The two notable observations, in our view, include the significant difference in both bookvalue growth and sales growth of our portfolio versus the two indices—particulary bookvalue growth. The important note on both sales and book-value measures is that they vary the least of the four between GAAP and non-GAAP. Notable too on this score is that the current accounting environment has seen the historical differences between GAAP and non-GAAP earnings are as great as ever. To illustrate these very real differences we have reproduced a graphic from our first quarter 2016 Client Letter.
The core element of our investment process revolves around superior profitability. The profitability that our companies generate represent value that our companies have created and captured. Our portfolio companies have three choices when they allocate this internally generated capital: Keep cash on the balance sheet (often in the form of deposits or long-term marketable securities); reinvest it in the business (in the form of capex, expenses or acquisitions); or pay it back to shareholders in the form of dividends and buybacks.
However, over the past few years of ultra-low interest rates, it seems that the first choice— keeping cash on the balance sheet—has actually become a value-destructive activity, both on an inflation adjusted and—more recently—a nominal basis. Nevertheless, our portfolio continues to have a very strong net cash to EBITDA ratio, with the majority of companies having more cash than debt. As such, the portfolio is “under-leveraged” compared with the broad S&P 500 Index, which typically carries a net debt to EBITDA ratio of about 1.8X. As a thought experiment, we assumed that our “under-leveraged” portfolio companies simply “leveraged-up” to the average net debt to EBITDA of the S&P 500. We found that these cash-rich companies in the portfolio could generate capital equal to between 15% and 20% of their respective market capitalizations. We do not that recommend our companies do this. However, at the very least we believe our thought experiment helps illustrate how strong balance sheets have actually led to weak relative performance. We do not know when or what drives the market to change tact, but until then, we continue to ignore the market’s plea to treat cash as a liability.
We can guess that monetary policy has had a significant hand in this development, but regardless of what is causing negative interest rates, we disagree with its embedded logic, namely, that a dollar of our companies’ profits today is worth less than a dollar of profits tomorrow. We would humbly argue that the Federal Reserve has increasingly become hostage to the current bull market. That said, if the tenets of prudent stock market investing are timeless and immutable, then bottom-up fundamental analysis plus valuation-sensitive price discovery will one day again trump Federal Reserve policy.
We discussed the chase for yield—and the related chase for “low-volatilty” stocks in our last Client Letter. Please consider too the graphics below on the historically stretched valuation of utility stocks earlier this year. (As a related aside, Vanguard closed its $30 billion Dividend Growth Fund to new investors back in July.)
See the full PDF below.
Value Managers Discussing Performance With Customers