QUOTE OF THE WEEK
“The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces.”
- Warren Buffett
Read more of our favorite value-investing quotes.
May 25, 2015
WHAT'S THE PROBLEM WITH 'DEEP VALUE?'
Today is unusual because we are closing five positions out of eight in our DEEP VALUE Portfolio at the open tomorrow morning. Absent a Market Down signal from our IMRA system, typically we might close one or maybe two positions in a week based on a stock meeting one of our sell-rule criteria. However, our IMRA system is in the bullish zone for small-capitalization stocks, and the market appears to be poised for turn higher. Still, we are going to put 70% of the DV portfolio in cash and have no stock candidates for replacements. What's going on?
For followers of our DEEP VALUE Portfolio, the recent underperformance is not new news. 2014 was extremely volatile, with an extended downturn in the middle of the year before a solid finish. 2015 has just been rotten, with the DV portfolio losing about 15% so far this year. This chart below shows the ugly facts. However, there is the promise for improvement on the horizon.
DEEP VALUE PORTFOLIO, PRIOR YEAR
The Deep Value Portfolio has struggled for the last year. However, there is an event on the horizon that should change that.
The recent underperformance by the Deep Value Portfolio is causing some issues. We find that many of our individual investor subscribers can get frustrated by underperformance in a very short time, cancel their subscriptions, and move on pretty quickly. It doesn't matter that we've beaten the market every year since 2004 and beaten it by an average factor of 15x in the last six years. For many, what's happening this week or this month trumps everything else. In our fast-paced world, patience is something that is a rare commodity, but unfortunately for those people, it's a necessity when it comes to investing. I wrote on the subject of patience a couple of weeks ago.
No investment strategy can ever be expected to work over each and every slice of time one may examine. Any stock selection system is going to have periods of underperformance and lagging the market. If we could find a system that outperformed every week of the year, we would have the 'Holy Grail' and Warren Buffett might be bidding to have lunch with us instead of the other way around. But that's not the case; in investing there are no holy grails. The stock market and stock investment systems have ups and downs. Savvy subscribers know that if the core strategy of the system is sound, the portfolio will recover.
OUT OF FASHION, OR A STRUCTURAL CHANGE?
Sometimes, a particular approach is using factors that go out of fashion for a while; it happens periodically. Sometimes, the market changes in structural ways and once-good strategies lose effectiveness, perhaps permanently. We can quickly identify several historical periods when the market was exhibiting structural conditions that were easily exploited by single-purpose strategies. For example, the dot-com bubble of the late 1990s is an example of a time when systems that focused on Price-to-Sales did exceptionally well.
The reason is that there was a multitude of start-up, internet-based companies that were generating sales but no profits. Investors were bidding up these businesses based on the euphoria over the 'new economy' that many believed had begun. Stock-selection screens with a dominant Price/Sales factor but neglect of all the other necessary company-valuation fundamentals such as earnings, book value, cash flow, and others still performed incredibly well. Many of us were around to remember that in early 2000, the dot-com bubble burst, and many lost their (paper) fortunes when those systems broke down. As a result, the Price/Sales ratio lost its cachet, and many system designers have eschewed its use ever since.
Another example is from the bottom of the 'Great Recession' market crash in early-2009. At that time, stock-analysis systems that emphasized cash performed incredibly well. The reason was logical: investors wanted companies that could survive and cash is the key to corporate survival. Cash is an accounting variable that can't be fudged like net earnings, and growth was something that many believed was never going to return. Therefore, businesses with reliable ratios related to Price/Cash Flow, Price/Free Cash Flow, Price/Current Assets, and Price-to-Cash-in-the-bank produced returns that were phenomenal.
RESULTS FROM A FOCUS ON SURVIVAL AND CASH
We can testify to that fact because IntelligentValue took great advantage of that situation. Having invested through the market downturns and bottoms in 1975, 1982, 1987, 1997 and 2003, we knew that there was an incredible opportunity at the point of maximum pessimism, and ratios heavily weighting cash would excel. As a result, when our IMRA system signaled Market Up on March 9, 2009, our asset-based Deep Value Portfolio system featuring cash ratios went to work. The result was a phenomenal return of 1649% over the remainder of that year. Every $10,000 invested grew to $164,900 in just nine months!
DEEP VALUE PORTFOLIO, 2009
In 2009, our DV Portfolio took incredible advantage of cash-related factors which insured that the companies would survive.
In the ensuing years, returns have moderated but have still been far above average, and even returned six times the market return in the difficult year of 2014. You can see the year-by-year historical results here. This continuing solid performance is a result of using flexible value-based factors and formulas, adding to - or subtracting from - weighting based on the current market environment. As the recovery moved through its stages, those cash-and-asset-based factors become less important, and instead we can combine value with an emphasis on growth, quality and momentum.
MISPRICING DUE TO OVER-REACTION
Unfortunately, a deep-value-oriented portfolio is dependent upon normal market gyrations for its success. As the market regularly rallies and overshoots its fair value because of investor greed, the ensuing result is consolidations, downturns, and selloffs. The DEEP VALUE Portfolio takes advantage of these regular market gyrations by exiting and moving to cash when the market begins to drop from a top. It then buys a full set of deeply undervalued stocks when the subsequent selloff bottoms.
2009 was an exceptional, perhaps once-in-a-lifetime bottom of the market, but we don't need events like that for the DEEP VALUE Portfolio to work well. There was a selloff/correction in 2010, a splendid one in 2011, and another decent one in 2012. The DEEP VALUE Portfolio exited the market just as each of those downturns was getting underway, avoiding the return-destroying drawdowns. Then it reenters the market as our IMRA system signaled the time was appropriate. Exceptional returns were the result each year.
However, our DEEP VALUE Portfolio is dependent on these regular market gyrations for its success. A steady, boring market with very little volatility leaves very little room for prices to become overheated and then subsequently oversold in panic. A deep-value investor’s primary tool for success is the identification of mispricing of assets. In the words of value investing billionaire Seth Klarman, “If only one word is to be used to describe what Baupost (Klarman's hedge fund) does, that word should be: 'Mispricing'.
We look for mispricing due to over-reaction.”
A DULL PERIOD EQUALS POOR PROFITS
Since the excellent year of 2013, when our DEEP VALUE Portfolio recorded a return of 261%, stocks have been moving without the significant volatility that creates the opportunity for high returns. A market with minimal, sideways volatility is one of the worst environments for investing since there is little opportunity to identify and purchase mispriced equities at the bottom of selloffs/corrections.
This situation is the source of the recent anemic returns in the Deep Value Portfolio. The chart below shows the market since the 2009 bottom, with blue arrows in the lower window identifying times when the Bollinger Band Width (a measure of the standard deviation of prices from a moving average) spiked to 20 or more. Since March 2013, Bollinger Bandwidth has steadily declined, and with it deep-value investing opportunities.
Volatility = opportunity: The strong gyrations of the last six years provided excellent value investing opportunities under our system. Low volatility since early 2013 has made returns flounder. That should change soon.
However, take heart DEEP VALUE investors! Periods of price lethargy don't last forever. The current stretch of three years without a 10% correction is extreme, and the market is long overdue for a significant drawdown. When complacency gets high, that's when Mr. Market throws a tantrum. While most investors see these tantrums as crises to be avoided, we see dollar signs. The key is knowing when to get out and went to get in.
Our DV portfolio system is telling us that this may be the time to begin a slow exit by moving us towards cash. It is exiting the current positions , which weren't doing great anyway, and it is not finding any stocks which meet the value criteria. We will take it week-by-week and respond to what the market presents to us. We WILL NOT be attempting to use our judgement to override the system and buy stocks just to have full portfolios. Subscribers who wish to be successful and reap the rewards of the DEEP VALUE Portfolio results should be patient and wait for the proper opportunity to present itself.
Based on history, it shouldn't be much longer. "Mispricing due to over-reaction" is part of human nature, and we will put that powerful force to work for us when the time is right.
We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit. Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach. If you have any questions or comments, please contact us with a support ticket.
Best Wishes for Another Week of Intelligent Value Investing,
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Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. If you are not sure if value investing or a particular investment is right for you, we urge you to consult with a Certified Financial Advisor. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.