Euclidean 4Q15 Letter – The Time For Value

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Euclidean letter for the fourth quarter ended December 31, 2015, titled, “The Time For Value.”

We believe that now is a very attractive time to invest in value strategies. Following similar times in the past, value investors achieved both strong absolute returns and robust relative performance versus the broad market indexes. In this letter, we explore what history can teach us about what is to come. We also review Euclidean’s investment approach to explain how we are positioned to capitalize on this opportunity.


Our confidence in Euclidean’s investment philosophy comes from using machine learning to study the history of public companies and their market values. Over the past 50 years, abundant evidence shows that it would have been fruitful to buy companies that were priced very low in relation to their earnings. Moreover, our own research suggests that this has particularly been the case for companies that also have a combination of consistent operations, good returns on capital, and balance sheet strength. This is why we formed Euclidean: to oversee a systematic process that seeks to invest in good companies at very low prices.

However, during recent years, Euclidean’s returns have been below market averages. As discussed in prior communications, these results have come during an extended period of growth stocks outperforming their out-of-favor value counterparts. In this context, the S&P 500’s performance has been driven by a small number of companies. The index’s two best performers of 2015 were Amazon (+118%) and Netflix (+134%), with price-to-earnings ratios of approximately 900 and 300, respectively. Given that the lower of these valuation multiples is almost 25 times more expensive than the average Euclidean holding, it is no surprise that we have missed these recent gains.

There are other unusual – and unsustainable – aspects of this current market. Joel Greenblatt, a prominent member of the “buy good companies at good prices” school of investing, shared the following observations in a September 2015 note to investors [1]:

Buying only those companies that lose money has earned investors anywhere from 20% to 50% over the last twelve months.

This is the first time since the late 1990s that over 80% of IPOs are losing money.

Buying the top momentum stocks and shorting the bottom momentum stocks (from the Morgan Stanley momentum index) would have achieved positive 18% returns so far this year whereas buying the top value stocks and shorting the bottom value stocks (from the Morgan Stanley value index) would have lost 13%.

These observations should give all investors pause. If you have not been participating in the market’s recent gains, should you pivot your investment process based on what has recently worked in the markets? Here are three reasons why we believe the answer is no:

  1.   Companies derive their intrinsic value from their ability to generate cash. It is, therefore, speculative to invest in companies that have not yet demonstrated an ability to consistently deliver earnings.
  2.   Across long periods, abundant evidence suggests that getting the most earning power for your dollar has been the key to investment success.
  3.   Following periods when buying companies on sale (#2 above) has fallen out of favor, value strategies have consistently reasserted themselves through strong absolute and relative performance. We hope to clearly illustrate this point in the charts that follow.

Let’s dig into these points to understand why we believe now is the time to add capital to value strategies.

Euclidean – Refresher on the long-term performance of simple systematic approaches to value investing

Last year, we shared with you the simulated results below, which show the annualized performance by decade of four simple value-oriented approaches for selecting equity investments. [2]

The results are compelling. The simulations reflect investing in inexpensive companies, where inexpensiveness means being among the cheapest 10% of all companies as ranked by a respective value factor. Clearly, a good route to realizing above-average returns would have been adhering to a process — even a very simple one — for buying companies at low prices in relation to their sales, book values, or earnings.

Yet, as we will see, achieving these returns over the long run requires enduring periods where buying inexpensive companies does not yield good results.

Euclidean – Market Cycles

Although value investing has performed well over the long term, it is also clear that it has not performed well all of the time. The charts that follow represent one of the most widely researched approaches to value investing, where a value stock is defined as one having high book equity to market equity. We will look through two lenses at the cycles value investors have endured along the way to superior returns. The first relates to how value investing has performed versus the S&P 500 market index. The second relates to how it has done versus growth stock investing.

Value vs. the S&P 500 Index

Since 1962 [3], a hypothetical portfolio based on this value approach [4] would have grown almost 10 times more than the same money invested in the S&P 500. Yet, while this form of value investing would have done exceptionally well over the long run, it has performed poorly during recent years. So, perhaps the right question is: does value investing still work?

You might have asked that same question in 1966, 1973, 1980, 1991, 1999, 2003, and 2009. At those times, the same value approach behind the returns described above would have underperformed the S&P 500 for multiple years, in some cases by more than 30%. This chart illustrates this point. The top section shows the hypothetical cumulative returns of the value approach versus the S&P 500 total return (i.e., price appreciation plus dividends) between 1962 and September 2015. The bottom part of the chart shows the drawdowns of the value approach relative to the S&P 500. [5] 

Clearly, value investing has endured many long periods of underperformance despite its long-term success. In fact, we are currently in the midst of such a period. But what happens when these periods end? To answer that question, we plotted the two-year hypothetical return of this value strategy starting from the bottom of the six largest relative drawdowns experienced prior to the current one.

While it may seem obvious that the relative returns of this value strategy might be strong once its relative performance turned around, the charts also show that strong absolute returns have been realized in each value recovery.

Euclidean – Value vs. Growth Investing

The prior charts show how value investing has performed versus the S&P 500 market index. The graphs that follow examine the cycles involved in buying inexpensive (VALUE) companies versus expensive (GROWTH) companies. We shared this analysis earlier this year and have updated it with data through November. We believe this lens remains particularly relevant, as we are currently in the midst of the longest period of growth stock dominance since World War II.

The returns above [6] reflect the trailing five-year annualized return of a hypothetical portfolio (the value vs. growth portfolio) that goes up when value stocks are outperforming growth stocks and down when growth is outperforming value. In this case, we look at the relative performance of the 20% least expensive (VALUE) companies in relation to the 20% most expensive (GROWTH) companies. All returns are compounded monthly.

The chart shows that value outperforms growth across most five-year periods. In fact, it does so by roughly 5% annualized over time. However, since World War II, there have been six distinct periods when growth outperformed value on a trailing five-year compounded return basis. We are currently in one of these periods, with the prior one occurring during the dot-com era.

Therefore, it is of great interest to examine how value has previously performed following similar times in the past. This chart provides a perspective.

During the previous five periods when growth outperformed value, value subsequently delivered very strong results over the subsequent 5+ years. In the current cycle, the value rebound has not yet occurred.

Cycles – Takeaways

In both cases, as we examine value investing in relation to growth stocks and to the S&P 500 index, we hope you take away three things:

  1.   The periodic underperformance of value strategies has not erased their superior results over the long term.
  2.   When value strategies endure a period of underperformance, they have subsequently delivered very strong absolute and relative returns.
  3.   That value investing has done well over time, but hasn’t worked all of the time, reflects an important point. Periods of underperformance make value strategies difficult to stick with. If value investing was both fruitful and easy, more would embrace it, and the opportunity to do well with value strategies would be competed away.

It is worth pondering this third statement. It reminds us of a famous Steve Jobs quote on what separates successful and unsuccessful entrepreneurs:

“I’m convinced that about half of what separates the successful entrepreneurs from the non-successful ones is pure perseverance.”

We believe the same could be said of value investors. The superior long-term returns offered by value strategies would have accrued only to investors with the conviction to persevere across difficult periods. Why would it be any different today?

Euclidean – How These Studies Relate to Our Investment Process

Years ago, we caught our first glimpse of the insights presented earlier in this letter, and they made us wonder: if the discipline of adhering to simple rules for investing in inexpensive companies would have done well across long periods in the past, might there be an opportunity to do even better by taking a deeper look at companies’ fundamentals? This led us to start Euclidean. We wanted a process-driven approach, informed by these sorts of lessons from history, for investing our own money.

As we set off on this adventure, we focused on seeking timeless lessons regarding how to tell if one company is inherently more valuable than another. We also searched for historical context about the prices you can safely pay for a given company when seeking to compound wealth over long periods.

As we pursued this wisdom, we found it helpful to imagine how an exceptional investor might evaluate a potential investment. After becoming familiar with how a company serves customers, manages expenses, and deploys capital, we felt this investor would compare the company with his experiences involving similar investments from the past. To the extent that those analogs, or “comparables,” in the past had done well, we suspected that his confidence in the new opportunity would be high, and the opposite would also be true.

It became clear to us that this investor’s success must come from being exceptional in three respects. The first one is obvious – he must accumulate a significant number of meaningful experiences on which to rely on when making decisions. Next, he must distill the right lessons from a lifetime of experience that was surely peppered with red herrings – for example, foolish investments that luckily worked out and instances when sound application of his expertise led to losses. Lastly, he would need a high level of discipline to avoid deviating from a robust investment process seeped in his historical experiences, particularly given the frequency with which his investments would underperform the market and more speculative forms of investing.

With this image in mind, we aspired to emulate these qualities of our exceptional investor through data. We knew from our own experiences building a business that how well a company serves customers, manages expenses, and deploys capital is reflected in its financial statements. So, our first step was to use machine-learning technologies to digest the financial statements and investment outcomes of public companies going back many years.

This gave us a basis for evaluating today’s equity investment options in light of how similar opportunities in the past actually performed. This step also showed that the historical record is full of support for the notion that there are persistent principles for evaluating companies and estimating the prices at which they tend to make good long-term investments. These principles are easy to understand and, characterized by findings such as “all else being equal, lower prices are better than higher prices”, are grounded in common sense.

Our next steps were to develop an infrastructure for overseeing a systematic application of these principles. And, as we anticipated that the pendulum of history would expose us to periods of challenging performance, to commit to adhering to this process through thick and thin.

Thus, we continue to maintain and establish holdings in good companies at attractive prices. Because of the relative attractiveness of our portfolio, as highlighted on the following page, and the context of how value and growth investing cycles have worked over time, we expect to deliver attractive long-term results to Euclidean’s investors.

Best Regards,

John & Mike

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