December 19, 2011

Outlook 2012: Value Investing — A Glimmer in the Gloom

Warren Buffett and Benjamin Graham’s influence still inspires today’s value investors

Warren Buffett, the Oracle of Omaha, speaks. (Photo: AP) Warren Buffett, the Oracle of Omaha, speaks. (Photo: AP)

Advisors are urging clients to shed their fear of equities and jump into the market next year because stock valuations are currently at their lowest point since the early 1990s. Value investing, they say, is the name of the game.

True, market volatility is also at historic levels thanks to the U.S. budget war in Washington, the European debt crisis and the vagaries of automated trading. In 2011, the average daily change in the S&P 500 since the start of August has been 1.7%, up or down, which is more than twice its daily average over the last 20 years, according to J.P. Morgan Funds Chief Market Strategist David Kelly.

“But at the other extreme are valuations, with U.S. and developed country stocks trading at some of the lowest earnings multiples seen in the last two decades and real 10-year Treasury yields in negative territory relative to core inflation for the first time in over three decades,” Kelly wrote in a Dec. 5 analyst note.

But value investors—an optimistic group with a natural inclination toward seeing light at the end of just about any tunnel—look at today’s lousy global economy and feel good about slow but steady growth, low inflation and all the unspent cash that companies are now sitting on. They look at undervalued stocks and see a buying opportunity.

Apple and Asia: A Good Match

“While the U.S. economy is easily below trend growth, corporate earnings as measured by S&P 500 companies are doing fantastic,” said David Rolfe, chief investment officer of St. Louis-based Wedgewood Partners and portfolio manager of the RiverPark/Wedgewood Fund (RWGIX). “They get a tremendous percentage of their earnings from overseas. So many of these companies are multinational. When you have Apple Corp. growing at triple digits in Asia, that’s the offset.”

Rolfe, a self-identified value investor who this year won Investment Advisor magazine’s large cap growth award, asserted that not only is Apple (AAPL) underpriced, but so is value investment guru Warren Buffett’s company, Berkshire Hathaway (BRK.B).

Apple and Berkshire, undervalued. Really?

“Dramatically so,” said Rolfe, who includes both companies among his top holdings. “When we bought Apple in late 2005 it was about

$60 a share. Now the stock is almost $400. The stock has been a dandy performer, but it hasn’t even come close to keeping pace with earnings growth. We believe that consensus expectations for Apple for the next 12 months are approximately $35 a share, and we think that’s far too pessimistic and the number will be closer to $40 or $45.”

As for Berkshire Hathaway, Rolfe noted that CEO Buffett bought his own stock back in September because he knew how cheap it was. “The master himself is basically pounding the table that Berkshire is cheap,” Rolfe said.

Stock-Picking the Buffett and Graham Way

Value investing is not a set of hard-and-fast rules, according to Christopher Browne, a managing director at Tweedy, Browne Co. and author of “The Little Book of Value Investing” (2007, John Wiley & Sons). “It provides guidelines that can point you in the direction of good stocks, and just as importantly, steer you away from bad stocks.”

Browne lays out in his book the favorite stock-picking methods of Buffett as well as his mentor, Benjamin Graham, the man who invented value investing and believed that investment is most intelligent when it is most businesslike. That said, their favored method is to buy stocks that sell at a low multiple of earnings. Earnings-to-stock price is measured by comparing the price-to-earnings (P/E) ratio to other companies and broader indexes, with P/E determined by dividing a company’s stock price by its earnings per share. The lower the P/E, the higher the earnings yield.

“The concept of earnings yield is helpful when comparing investment opportunities,” Browne writes. “Graham did this. For example, a stock selling at 10 times earnings has an earnings yield of 10%. Compare this with a 10-year Treasury note yielding 5%, and you get twice the return.”

Today, value investors such as Craig Callahan, founder of the $2 billion ICON Funds and portfolio manager of Icon’s Core Equity Fund (ICNIX) use Graham’s central value formula to take the emotion out of their stock picks.

“We count on investors over-reacting, and we try to exploit it by buying at a discount or by selling overpriced stock,” Callahan said.

He acknowledged that the last couple of years have been tricky for value investors because of the U.S. recession and Europe’s troubles. Yet, even the European debt problem, which Callahan refuses to call a crisis, is in his eyes nothing more than an interruption in the markets’ forward march.

Callahan’s current undervalued favorites are GE, Nike, Caterpillar and—like Rolfe—Apple. “I tell people who are worried about the economy to go into an Apple store on a Saturday,” he said.

Growth Guys Not So Keen on Value

Not all stock pickers are value investors, though.

Jim Oberweis, who manages the Oberweis Emerging Growth Fund (OBEGX), notes that he got his investing chops during the boom times of the 1990s, when growth stocks were a better buy than value stocks. Today, he believes that value is overvalued and poised to take a tumble.

“The pendulum swings,” Oberweis observed. “The problem for value stocks is that everybody is trying to buy them right now.”

Aggressive funds such as his tend to face headwinds when value stocks outperform growth stocks, which was the case from 2000 through 2008, Oberweis said. (In fact, during that period, value stocks outperformed growth stocks by historic margins.) But now, he sees opportunities in small, nimble companies that are profiting from stagnant growth in the U.S. For example, Oberweis is a buyer of HMS (HMSY), a Medicaid audit recovery contractor.

Admittedly, the six funds managed by Oberweis Funds are all growth funds, according to Oberweis. Nevertheless, he believes that hot growth stocks are well positioned to overtake value stocks, which is why he’s seeking small companies with positive cash flow and revenues and earnings that are likely to increase at a faster rate than the average company.

‘Excellent’ Balance Sheets Augur Well for Buybacks, Dividend Increases, M&A

Either way, whether a person is positioned for value or growth, 2012 looks to be a surprisingly good year for stock investors.

“Very worrisome macro issues have created an atmosphere of pervasive pessimism,” said Kent Croft, CIO and portfolio manager of the Croft Value Fund (CLVFX), in a written comment. “Bottom-up fundamentals of companies tend to be drowned out in times like these, creating an attractive entry point for investors heading into 2012.

Companies continue to maintain excellent balance sheets which augur well for continued buybacks, dividend increases, and mergers and acquisitions, Croft added, noting that 2011 share repurchases are at their highest levels since 2007. “Dividend payouts will come close to their 2008 peak,” he said, “and companies are generating excellent free cash flow, which will add to their record $2 trillion-plus hoard of liquid assets.”

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