Value Investing is SAFE and Cheap, Not CHEAP and Safe

I would ask yourself how to implement value investing in an era where debt is no longer expanding. Arguably an era where inflation is increasing (albeit from a low starting point).

A few years ago, everyone “knew” housing prices never went down nation wide. Today, CNBC constantly tells us that the consumer is 70% of the economy… undoubtedly true when debt levels were expanding. But consumer income is not growing as fast as the cost of living, and debt levels cannot expand again. The “consumer is 70% of the economy” assumption probably won’t hold over the next few decades like it did in the past few decades. How does one implement value investing in such an environment?

 

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Value Investing is SAFE and Cheap, Not CHEAP and Safe

So asked on reader in response to last night’s post.  His full comment was similar to some of the musings of Bill Gross, in that we don’t live long enough to really prove we have skill in investing, but over the last 40 years the overall macroeconomic regime of expanding debt favored certain classes of investors.

A few thoughts:

1) Value investing is SAFE and cheap, not CHEAP and safe.  Focus on margin of safety.  Spend time asking what can go wrong.  Test the strength of moats.

2) In 2008-2009, there were a lot of value investors that got savaged.  Why?  They invested a lot in statistically cheap financial companies that were carrying a lot of credit risk.  Having worked for a hedge fund 2003-2007 that did the opposite, my own investing was constrained because I feared what might happen when the bear part of the credit cycle emerged (leaving aside a mortgage REIT that I foolishly held onto).

Credit-sensitive financials are like cyclical non-financials that have over-invested in productive capacity.  They have high operating leverage, and will only prosper when demand is strong/credit is good.  Cyclical companies often have low P/E multiples near the top of the cycle, because the bear phase is anticipated.  They have high or negative P/E multiples near the bottom of the cycle, because the bull phase is anticipated.

The main idea here is to be skeptical of companies carrying a lot of credit risk, particularly after they have succeeded for some time.  When the credit risk manifests, it is savage.

3)   Avoid debt and products that require it.  My portfolios ordinarily avoid companies with a lot of debt.  I like companies that finance themselves internally through retained earnings.  During bear market phases, companies with financial flexibility do better.  It is always better to get financing at a time when you don’t *have* to get it.  Seeking liquidity when little is available is never an attractive place to be.

Also remember that big ticket items like houses, cars, boats, RVs, college educations, do badly when credit conditions tighten.  Luxuries are disadvantaged versus necessities also.  Before the bear part of the credit cycle hits, own companies that are self-financing, and have stable revenues.

4) Inflation tends to favor value investing based on flow (income statement, cash flow statement) versus stock (balance sheet).  In one sense, corporate pricing power boosts the value of companies that can pass on the inflation and then some.  This was true in the ’70s when value investor did relatively well.

In summary, I would say that in the future, value investors need to focus on:

  • Safety first
  • Avoidance of credit risk, implicit and explicit
  • Investing in companies that don’t have to seek external finance
  • Companies that can pass on the effects of inflation.

 

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.