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Your value investing style through the cycle


Lupo Lupus
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Is it a good idea to adjust your value investment style depending on the stage of the market cycle? I am not talking about how value investing in general performs over the cycle (which has been analyzed before) but what to choose *within* the value universe. For instance, one view would be that in a depression (2009) to focus on securities that are classic deep value (eg, statistically cheap) and to move into more quality assets later in the cycle (eg, now). Problem with this is that everybody wants to move into quality at this stage, so this may be a self-defeating strategy...

 

Any thoughts on this?

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Is it a good idea to adjust your value investment style depending on the stage of the market cycle? I am not talking about how value investing in general performs over the cycle (which has been analyzed before) but what to choose *within* the value universe. For instance, one view would be that in a depression (2009) to focus on securities that are classic deep value (eg, statistically cheap) and to move into more quality assets later in the cycle (eg, now). Problem with this is that everybody wants to move into quality at this stage, so this may be a self-defeating strategy...

 

Any thoughts on this?

No pratical experience on this (downturns). My take is that it would be wise to move into cycle resistant or counter cyclical stocks late in the cycle. Maybe not with all the portfolio but at least with a decent part (otherwise you would be trying to time the end of the cycle).

 

This doesn't mean moving from low quality to quality. A good company may be cyclical and a reasonable company may be acyclical. For example, you could buy an highly regulated utility and still keep casinos and restaurants you have in your portfolio. If the cycle continues you make money, if it doesn't you have a way to get the money you need to go deep value. That is what I am trying to do right now: bought an acyclical utility last month at a 10-13 net income (depending on the legality of a recurring extraordinary tax on assets), while keeping the remaining portfolio. My take is I won't lose more than 10-20% on the utility (while some companies would go down 60 to 90% in the same context)

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So, to "adjust" or not?

 

Thought process:

Where are you in the spectrum?

1-ability/"ease" to find opportunities within universe (circle of competence): no vs yes

2-holding period: "short" term vs "long" term

3-attitude about the future (margin of safety): something to "protect" against vs expectations/"potential"

4-relevance of mean reversion: high vs low

 

If you can find opportunities that you want to hold for a long time and that offers reasonable prospects of satisfactory returns whatever economic conditions, I would submit that you don't need to "adjust".

 

Apologies as this post probably provides more questions than answers.

I wonder where prudent optimism fits in that spectrum.

 

 

 

 

 

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An interesting question that I wrestle with. 

 

Aside from my oil holdings I have moved into things I consider safe, with less growth potential than I would normally like.  Utilities are a big part of this: Bep.un; Aqn, Enb, Ema-TSX; 

 

Obviously my returns will suffer if interest rates rise rapidly.  But, should there be a downturn I would expect interest rate rises to be put on hold or even reversed. 

 

None of us can predict what will happen going forward.  Central banks worldwide have messed up the normal business cycle.  So, we kind of have to protect against a number of scenarios. 

 

One thing I am sure of is that there isn't much that is cheap right now.  I was screening a few Nasdaq stocks this morning and the PE ratios are very high. 

 

If I were a betting man, which I am, I figure that oil prices will continue to rise and will ultimately generate a market pullback and recession.  Oil prices have less effect overall but are still a huge and important part of the economy.  If they rise too high prices for everything go up.  Central banks would like to keep raising rates so they have ammunition in the next downturn but I am not sure they can do much before the next recession. 

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Not popular .. but simply learn how to be 'idle'.

 

Only buy when quality is available and cheap, and sit in treasuries when it isn't. You'll always be loading up a little after the cycle has turned up, and selling a little after the cycle has turned down. Worst case you suffer some opportunity loss from late buys & sells, and have to put up with a high cash position through the downturn.

 

SD

 

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Is it a good idea to adjust your value investment style depending on the stage of the market cycle? I am not talking about how value investing in general performs over the cycle (which has been analyzed before) but what to choose *within* the value universe. For instance, one view would be that in a depression (2009) to focus on securities that are classic deep value (eg, statistically cheap) and to move into more quality assets later in the cycle (eg, now). Problem with this is that everybody wants to move into quality at this stage, so this may be a self-defeating strategy...

 

Any thoughts on this?

 

I'm a big advocate for not adjusting your strategy at all over time.  Otherwise what happens is you relax your valuation standards over time.  There's no question that growth (future increases in intrinsic value) vs value (the degree of discount to present intrinsic value) are both worth something, and you have to decide for yourself how much they are worth.  If you demand more, you will generally take less risk, but if you demand too much you'll probably never do much investing.

 

For me I want to get my money back on whatever I pay for the enterprise (vs the balance sheet) within 10 years.  There are almost no assets currently that offer that, so I don't buy anything.  It takes a lot of discipline to keep your standards invariant.  You are also forced into a concentrated portfolio of 10-20 securities in all but the most depressed of times.

 

People talk a lot about sector rotation.  I guess this doesn't affect me much except to the extent that people who don't know how to value businesses overrotate out of a sector from time to time and expose some values.  I picked up some nice tech values in 2016 before people rotated back into tech.  But if they're still good businesses and not massively overvalued, why would I rotate out of them?

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Not popular .. but simply learn how to be 'idle'.

 

Only buy when quality is available and cheap, and sit in treasuries when it isn't. You'll always be loading up a little after the cycle has turned up, and selling a little after the cycle has turned down. Worst case you suffer some opportunity loss from late buys & sells, and have to put up with a high cash position through the downturn.

 

SD

 

I like this view. In this way the proportion of different value styles in the portfolio (say optically cheap vs quality) will vary over the cycle, but passively. You buy whatever "style" is cheap so to make full use of current opportunities, without actively adjusting the investing styles or search strategy. I think Cliff Asness has made a similar point as regards to factor investing.

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I now buy value crypto's

 

What ratios do you look at to determine value? I mainly use P/E (price / earlier price) but more suggestions would be appreciated.

 

The problem with that approach is that it penalizes growth. I first match to an exponential curve to get a growth rate and then I divide the PE by the growth to get  PEG ratio. Basically I'm banking on mean reversion to the intrinsic exponential.

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I think it's more important to find an investing style that works and that you're comfortable with through the cycle and that you'll stick with rather than bounce around between styles too much.

 

Much of my biggest mistakes in investing came from trying to do things that didn't really feel natural to me, but I was trying to imitate the style of investors I admired at the time (deep value, cyclicals, etc)

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I'm a big advocate for not adjusting your strategy at all over time.  Otherwise what happens is you relax your valuation standards over time.  There's no question that growth (future increases in intrinsic value) vs value (the degree of discount to present intrinsic value) are both worth something, and you have to decide for yourself how much they are worth.  If you demand more, you will generally take less risk, but if you demand too much you'll probably never do much investing.

 

The problem with this is that it keeps people out of the game in "reasonable" times. Jan 2017, people thought the market was reasonably valued. A lot of people kept cash on the sidelines. That hurt as 2017 ended.

 

IMHO, investors need to keep in mind two things: (1) financial gravity aka interest rates, and (2) long-term value. Long-term value may mean buying something at 20x earnings because firstly, nothing else is cheap, and secondly, it will continue growing value because it is a good business.

 

I am continuously reminded of a study where someone analyzed blue-chips in the 50s/60s/70s, and calculated their earnings yield at the time, vs. using a DCF over the next 20 years and calculating what their earnings yield "should have" been. PG for example was trading at something like 25-30x earnings (aka traditionally "expensive") but really should have been trading at like 55-60x earnings because it was a good business that kept growing.

 

 

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I now buy value crypto's

 

What ratios do you look at to determine value? I mainly use P/E (price / earlier price) but more suggestions would be appreciated.

 

I take a more technical approach: chartin... er, technical analysis.

 

It's easy to predict where support is with the long history of data available, and I like to trade in and out as the momentum swings.

 

It's akin to picking up pennies in front of a steamroller!

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"I am continuously reminded of a study where someone analyzed blue-chips in the 50s/60s/70s, and calculated their earnings yield at the time, vs. using a DCF over the next 20 years and calculating what their earnings yield "should have" been. PG for example was trading at something like 25-30x earnings (aka traditionally "expensive") but really should have been trading at like 55-60x earnings because it was a good business that kept growing."

 

LC,

The last part of this statement got me thinking. I had to find notes that I took in the late 1990's. I have followed PG for a long time.

From my notes (from Mr. Siegel's book Stocks for the Long Run, 1994), the yearly total return for PG from 1/1/72 to 31/5/93 was 12,6% versus the S&P at 12,0%.

Didn't check exactly but I assume that buying PG or the S&P in January 1973 (peak) would yield similar relative results.

BTW (1), for all nifty fifty stocks, according to Mr. Siegel, a similar picture emerge (although, if bought in January 1973, the basket of nifty fifty stocks slightly underperformed the S&P from 01/1973 to 05/1993.

BTW (2), the nifty fifty group is not so well defined (in terms on how to tabulate results over time as firms merged, disappeared etc) and other authors using other methods and criteria have come up with results that are not as good for the nifty fifty stocks relative to the S&P.

For fun, I am adding that for MMM (a previous holding of yours, I understand) the total annual return over the 1972-93 period was 10,0%

 

Could you share the study that you refer to?

I understand that we should pay up for quality because, in the long run, time is our friend.

 

My questions:

Do you consider that it was worth it to pay up for PG (quality) in 1972-3 vs the index?

Do you think that most investors held the nifty fifty stocks in 1973-4 when they cratered more than the market?

Do you think that the average investor holding period is more than 20 years?

 

 

 

 

 

 

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Cigarbutt,

 

I have been trying to find the study for years now. I read it about 5 years or so ago. I think it was published by Sanjay Bankshay (spelling?)

 

For your questions

 

1) If it underperformed the S&P over that timeframe (incl dividends etc etc) then definitely not...so that I guess it the hole in the armor

2) I really don't know for the second question...perhaps? My perspective is skewed because I wasnt alive for that market, so I don't know if investors were more blue-chip hold-forever inspired? I really just don't know.

3) I don't think so  ;D ;D

 

 

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Hey I think I found it!

https://www.dropbox.com/s/haqe3psl29u1scx/October_Quest_2013.pdf?dl=0

 

I got the name (PG) wrong (well kind of, he does an analysis of PG India vs. PG) but the general point is there. It's essentially about the undervaluation of quality businesses. We think 25x earnings is not undervalued but in many cases that turns out to be exactly the case. I.e. 'good business at fair price'.

 

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OK.

Found this too:

www.valuewalk.com/wp-content/uploads/2015/07/Roller-Coaster-Investing.pdf

 

"If you end up owning a fantastic business, then plan to hold it for a long time. And prepare yourself for a roller coster ride. If you have chosen the right business to own, the ride will be worth it."

 

But I'm still confused:

http://www.thewealthwisher.com/2017/05/28/pe-ratio-nifty-valuation/

 

Recent Quote from Professor Bakshi (2017?):

"Recent research done by my firm shows just how dangerous it is to remain invested in an expensive market. Since NSE started, every time when Nifty’s Price/Earnings ratio exceeded 22, the average return from Indian equities over the subsequent three years became negative.”

 

Thanks for the reference as the gentleman is interesting. He often refers to Mr. Buffett. Of course, we know how Mr. Buffett handled the early 70's.

I'm really trying to understand the interest rate law of gravity. Not there yet.

 

 

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james22,

Your expectations or the market's? :)

 

FWIW, I think LC's point about paying for quality is a good one (anytime through the cycle).

With all due respect, it's just that the underlying reasons justifying the conclusion were not exactly convincing.

 

For those interested, here's a link showing a follow-up of Mr. Siegel's work published in 1998.

He showns that an investor buying/holding Philip Morris, Pfizer, Bristol-Myers, Gillette and Coca-Cola in 1972 would have done very well over time and that meant buying/holding securities with relatively high PEs (Coke at 46,4!).

 

We know now that 1987-9 was a better time to buy KO but it was already a good target in the early 1970's.

The table also shows that Lubrizol was not an ideal candidate then.

 

In retrospect, for these 5 specific top nifty companies, even in a different interest rate environment, the stocks were "cheap"...

 

Even JNJ with a PE of 57,1 and Disney at 71,2, were fair deals.

 

https://www.aaii.com/journal/article/valuing-growth-stocks-revisiting-the-nifty-fifty

 

 

 

 

 

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I don't have a plan for altering my strategy as the cycle progresses, but I am accidentally doing it anyway. A lot of the high-quality US names that I bought on dumb multiples between 2008 and 2011 now look fully priced. I feel like it might now be easier to make asset allocation calls along the lines of what Jeremy Grantham recommends in GMO's Q3 newsletter - in other words, avoid the US and move to EAFE and particularly EM. I can't stockpick these markets but I can use ETFs. The relative valuations suggest that EM and EAFE should outperform the US from here whether we get a bull market (in which case I win) or a bear market (in which case I get to protect more of my capital for the next value spree).

 

This is not a recommendation, just what I have found myself doing.

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