25 April 2019

Value Investors Face Existential Crisis

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Hunting for cheap stocks has been out of favor for so long that some self-proclaimed “value” investors are embracing a broader mandate, a potentially costly move in the later stages of an economic cycle.

Many such buyers have drifted away from the hallmark of value investing championed by the likes of Benjamin Graham and Warren Buffett : actively picking stocks the market has overlooked. Those legendary investors assessed what they called a company’s intrinsic value and compared it with metrics such as its cash flow and price-to-book ratio, a measure of net worth.

Value stocks—traditionally shares of consumer-staples companies, basic materials firms and big manufacturers, among others—have been stuck in a rut for most of the nine-year rally in U.S. stocks. The Russell index of 1,000 of the biggest value stocks in the market has fallen 2.1% in 2018, the fifth straight year—and the 10th of the past 11 years—that the index has lagged behind its growth counterpart, which is up 6.9%.

Some critics say the measures used to identify value have aged poorly in a market dominated by passive investing strategies and asset-light technology companies. Those trends have pushed more investors into the shares of fast-growing companies such as Apple Inc. and NetflixInc. that have powered the market higher in recent years. Other investors have turned to studying momentum trading, crowded positions, fund flows and event-driven trading, strategies not typically associated with value investing.

“One of the toughest things is being able to articulate what value investing is anymore,” said Laton Spahr, the portfolio manager of Oppenheimer’s value fund. “It’s hard to pinpoint what value investing is today, and that is the hard thing to making it relevant to retail clients again.”

Many investors say they aren’t looking back, even as most analysts generally agree the U.S. is in the later stages of an economic cycle. That would suggest stocks are due for a pullback, putting investors who have altered their strategies at risk of missing out if the pendulum swings back in favor of traditional value stocks that historically shine when the broader market is under pressure.

Perhaps one of the more controversial changes among value investors is the drift toward growth companies. Value investors who justify buying shares of Amazon.com Inc. or Netflix, for example, say it is because those companies are still undervalued by the broader market, despite their big revenue growth. Others call it portfolio window-dressing to boost returns.

Eddie Perkin, chief equity investment officer at Eaton Vance , said value funds that have ignored the hugely popular FANG stocks—Facebook Inc., Amazon, Netflix and Google parent Alphabet Inc. —run the risk of being left behind in the market.

“The FANG stocks are so dominant in those benchmarks that to not own them, you got really hurt the last few years,” he said. So you had to have those in your portfolio to keep up with other growth managers.”

Eaton Vance’s Large-Cap Value Fund, which has been in existence for more than 80 years, is tilted toward financial stocks such as JPMorgan Chase & Co. but also counts a position in Alphabet.

Even longtime value investors like Mr. Buffett eventually gave in to the changing value landscape, though his timing hasn’t been ideal. His conglomerate Berkshire Hathaway Inc. first took a position in Apple in early 2016, after the stock was already expensive by some measures, and has steadily increased its stake since then.

With a cash pile of about $110 billion, Mr. Buffett and Berkshire have a lot of flexibility to put their money to work. But his eye for value didn’t spot Amazon, a company that has disrupted the retail sector and has driven much of the broader market’s recent gains.

At Berkshire’s 2017 shareholder meeting, Mr. Buffett explained his reasoning for never investing in Amazon: “I was too dumb to realize what was going to happen,” he said.

Rather than embracing the popular tech stocks, Richard Mathieson, portfolio manager of the BlackRock Advantage Large Cap Value fund, tracks fund flows and other positions to identify crowded positions and find companies that may have been left behind. The fund invested in semiconductors, a corner of the technology market that isn’t a traditional value play but more investors say is becoming attractive due to growing demand for chips.

“Traditional value styles of buying cheap stocks has been in the doldrums for a long time,” Mr. Mathieson said. “Our approach to value has evolved.”

The BlackRock fund is down 0.7% this year, after posting a 15% return in 2017, its best gain over a 12-month period in four years.

For Mr. Spahr at Oppenheimer, the 2008 financial crisis marked a turning point, when accommodative monetary policies broadly lifted asset prices—to the detriment of value investors.

Over the past five years, Oppenheimer has been trying to determine which banks are in a position to surprise the market with higher capital returns or faster dividend growth during their annual stress tests.

“We had to become slightly more tactical and trade a little more. There’s more awareness of what the catalyst events are,” said Mr. Spahr, whose value fund is down 0.9% so far in 2018 after returning 10% last year.

Oppenheimer’s value fund still holds stocks for about three years, but the investment team will add to or sell down individual positions to juice or protect returns based on their analysis of those banks. “We trade our portfolios 20% more than we did 10 years ago,” he added.

His fund has also blurred the line between value and growth, taking stakes in Microsoft Corp. and UnitedHealth Group Inc., two stocks that Russell Indices classify as growth stocks.

“Anybody who is surviving in this world as a value investor has had to run outside the value benchmarks,” Mr. Spahr said.

Click here for the original article from The Wall Street Journal.

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