During a recent interview, a famous investor questioned whether value investing will ever return. With all the ways to invest these days, it seems like value investors are few and far between. Quant shops use machines to parse data. Passive exchange-traded funds track benchmarks. Top-down shops invest based on their assessment of macro-driven trends. Fewer investors care about the fundamental value of a company, which includes the worth of its assets and future cash flow streams. As a result, this famous investor argues, there are dislocations in the markets because nobody pays attention to what a company is actually worth.
We agree dislocations exist. Fewer people are making investment decisions based on carefully researched, fundamental valuations. We disagree that this means value investing may never return. Those who know how to properly value a company may be better poised to unearth opportunity before the rest of the market detects it, since there are now fewer folks who invest based on fundamental analysis.
What lies beneath
Markets have changed significantly since Mutual Series started focusing on value stocks in the late 1940s. There are fewer dedicated, fundamentally driven value managers. The markets themselves also look different. Machines running quantitatively managed active and passive strategies make up an increasing portion of the equity markets. Many of these programs classify stocks based on ratios such as price-to-sales (p/s), price-to-book (p/b) or price-to-earnings (p/e), which are pulled from a company’s financial statements.
Mechanical value investing driven purely by low p/e, low p/b and simple reversion to the mean has underperformed for over a decade. Pricing differentials among value companies have widened, with organizations that invest in their own technology and research and development infrastructure outperforming their peers. It is difficult to identify these companies simply by ratio analysis and mean reversion. However, analysis of future growth prospects, free cash flow generation, competitive positioning, and catalysts for corporate evolution can identify companies potentially poised for outperformance. Since it can take a while for these slow-moving waters to carve a better company, screens used by non-fundamental investors may not immediately register the effects.
The big short
Short-sightedness has become an epidemic in investing. Meme stocks have convinced retail investors that getting rich overnight is a viable plan. Companies that are not eating everything in their path and growing quickly are unexciting. We don’t buy into this hype. Underneath the flash, real things are happening.
Some companies throw off significant amounts of free cash flow and use it to build shareholder value. Building shareholder value can involve investing in organic growth capabilities, making accretive acquisitions, or making meaningful capital returns to shareholders through share repurchases and dividend payments. These positive actions can increase the value of a company slowly over time. Investment managers performing true fundamental analysis can potentially spot these stocks before other investors. As companies become increasingly misvalued, the opportunity set grows. When compared to high turnover, short-sighted investing, this strategy takes time and patience.
The color of money
Stock prices don’t immediately respond to the positive cues and metrics that illustrate value creation. In our view, the opportune strategy in long-only equity investing is to identify company activities that will potentially drive earnings and valuations higher, and which the market is not recognizing.
Many companies sell at depressed valuations. The reasons are varied and nuanced. We think businesses that continue to generate attractive free cash flow, and where the management team has a disciplined, returns-driven capital allocation strategy, can generate attractive opportunities. The recent stock market declines have provided chances to invest in companies with significant free cash flow generation and strong balance sheets for relatively low prices.
The prominence of value investing has decreased since 1940, but that does not mean fundamental analysis is any less relevant or effective today than it was then. With fewer market participants examining this information, it can create a multitude of opportunities for those still performing this valuable work.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions. Value securities may not increase in price as anticipated or may decline further in value.
Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.
IMPORTANT LEGAL INFORMATION
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.
Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.
