Market Musings 090922: Avoid super-expensive and loss-making stocks

“Cheap” value stocks are beating the stock market this year… .

Summary:

1. Value (and High Dividend) stocks are beating Growth this year.
2. Unprofitable stocks, and IPOs, are generally best avoided
3. The largest US stocks are often best avoided
4. Expensive PE stocks tend to do worse in the long run
5. Value is even better when combined with Quality
   

Podcast this week:
Warren Buffett: the investing “GOAT” (Greatest Of All Time)

• Does successful investing always start from childhood?
• Did Warren Buffett succeed due to his family background connections?
• What investment philosophy has Mr Buffett used? Has it changed?
• What are Mr Buffett’s recent successes and failures?
• How could I invest like Warren Buffett?
  

Recent monthly report:
Investment Strategy Focus: September 2022

Buying “cheap” and profitable stocks is a winning strategy in the long run

Many famed “value” investors investors such as Benjamin Graham have made a career out of the stock selection strategy of buying and holding stocks that are judged to be cheap on one or a number of valuation measures, such as:

• Price/book value - comparing the stock market value of a company to its accounting “book” value;
• Price/earnings (P/E) - comparing a company’s market value to its earnings (after-tax profits);
• Price/sales - comparing a company’s market value to its annual sales (also called turnover)
• Enterprise value (market value + value of debt) / Earnings Before Interest and Taxes (EBIT): like the P/E measure above, but takes account of a company’s debt as well as shares.

There are other valuation measures besides, but this captures the most noted measures investors typically use.

(By the way, if you are interested in knowing more about which of these works over the long run and why, and how you can even combine them, I recommend Jim O’Shaughnessy’s book “What Works on Wall Street”).

These value-based strategies of trying to buy a company for less than its “intrinsic value” and holding it until the share price more accurately reflects the company’s underlying true value have been outperforming strategies for decades, based largely on the original work of US professors Eugene Fama and Kenneth French.

But over the last 10+ years, these value strategies seem to have lost their mojo, with growth-based and momentum-based strategies typically doing better, particularly in the US where the technology sector has led the way.

However, over 2022 to date, value-based strategies have made a comeback, with the MSCI World Value index losing only 3% in euros, while the equivalent Growth index has lost 14%. .

In 2022, Value and Dividend strategies have outpaced Growth

Source: Bloomberg

Is there still any worth in these value-based stock strategies? I think there is. But perhaps a better way to think about the stock selection problem is rather: “What is best avoided when selecting stocks for a portfolio?”.

Unprofitable stocks, and IPOs, are generally best avoided

From the low point of the initial COVID crash in March 2020, retail investors became very excited by unprofitable technology stocks with very marketable narratives, such as exercise bike poster child Peloton. As a result, unprofitable tech stocks in the US went on a huge run up, gaining as much as 250% at peak by February 2021, less than a year later.

However, wind the clock forward to today, and this same group of unprofitable companies have given up all of those gains to return to their March 2020 lows.

Unprofitable US technology stocks have returned to Earth since February 2021

Source: Bloomberg

In general, while unprofitable companies (often marketed heavily in an Initial Public Offering when these companies are first brought to the stock market) often have compelling stories, they do not generally make good long-term investments.

From 2001 to 2020, unprofitable stocks in the US Russell 2000 small-cap index in aggregate made no money at all. Over the same period, profitable Russell 2000 stocks went up around 350%.

US profitable small-caps have vastly bettered unprofitable ones over time

Source: Factset

Conclusion: best to avoid unprofitable stocks

The largest US stocks are often best avoided

When we look at the largest companies by market value in the US today (like Microsoft, Apple and Google), we should remember that the top 10 in the S&P 500 index by size typically underperform in the 5-10 years after making the top 10, according to Forbes.

Note that their performance is typically stellar in the 3-5 years before they reach these dizzy heights, which is normal as that strong stock performance is what drives them into the Top 10 largest market capitalisations in the US stock market. But then, this strong performance typically fades within a few years.

The largest 10 stocks in the US S&P 500 index tend to underperform after making the Top 10

Source: Forbes

This makes sense, as these Top 10 companies have typically become rather expensive in valuation terms by this stage. This is particularly true at present, if we look at the chart below.

Top 10 US stocks today are historically expensive versus rest of US stock market

Source: Mike Zaccardi on Twitter

Conclusion: once companies have made it into this Top 10 list, their best stock market performance days may already be behind them… Perhaps better to look at companies outside this Top 10 list instead.

Expensive PE stocks tend to do worse in the long run

Taking just the basic price/earnings valuation measure, there is a big difference in performance between the most expensive (highest P/E) stocks versus the lowest. From 2000 to 2020, the most expensive 20% of US stocks by P/E underperformed the average stock by over 2% per year. In contrast, the cheapest 20% of US stocks by P/E outperformed by 1.4% per year on average. This is quite a noticeable difference. Note too in the chart how the underperformance is really concentrated in the most expensive stocks (1st quintile).

The highest P/E (most expensive) stocks underperform over time

Source: Fat Pitch Financials. Note: returns calculated from Jan 2000 to Dec 2020

Conclusion: So more than investing in the cheapest P/E stocks, a value-based stock selection system may  work perhaps more by cutting out the most expensive stocks.

Value is even better when combined with Quality

Combining Value with a Quality element improves overall performance, in a so-called “multi-factor” model. So choosing stocks based on a combination of value and quality measures is better than just using value alone, as it reduces some of the risk that one tends to be exposed to when choosing stocks on solely a value basis. It turns out that some stocks really are cheap for a good reason…

Since 2000, the S&P Quality, Value and Momentum multi-factor index (which selects stocks based on a combination of these three factors) has delivered an average annual return of 10.3% per year. This compared to 7.6% per year for Value alone, and 5.8% for Growth. Over the 22 years, this results in a huge level of outperformance by the multi-factor model.

A combination of US Value, Quality and Momentum has outperformed since 2000

Source: Bloomberg, S&P DJI, MSCI

Conclusion: While selecting stocks based on Value is good, combining Value with measures of profitability (Quality) and favouring stocks which are already performing well (Momentum) improves long-term performance.

Investment conclusions: Don’t be seduced just by Growth

• After a relatively long period where Momentum and Growth stocks have done very well (just look at the performance of the US Nasdaq index since 2009), the change in economic landscape (more volatile growth, higher inflation, higher interest rates) could now favour Value stocks going forwards.
• In sector terms, Value stocks tend to be found today more in the OIl & Gas, Mining, and Financials (Banks, Insurance) sectors.
• Mixing Value with profitability (Quality) makes sense both from an investment return and also from a risk reduction point of view. The strongest earnings momentum this year so far is clearly in the Oil & Gas sector, even with the recent pullback in crude oil prices.
• A quick perusal of the Stockopedia Top StockRanks screen (Quality + Value + Momentum) reveals a number of interesting companies including:
  
  Shell (LON:SHEL)
  Shoe Zone (LON:SHOE)
  Anglo Pacific (LON:APF)
  Glencore (LON:GLEN)
  Yellow Cake (LON:YCA)
  Natwest (LON:NWG)
  TP Icap (LON:TCAP)
  Renewables Infrastructure (LON:TRIG)
  NextEnergy Solar Fund (LON:NESF)
  Serica Energy (LON:SQZ)
  
  

Plenty of ideas for further research!

Have a great week

Edmund