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March 26, 2012 at 08:00 PM
Tevye the milkman.
He’s not the first person who comes to mind for the average value investor, but according to value guru Vitaliy Katsenelson, we can learn a lot from Tevye, the iconic farmer and defender of tradition from the musical Fiddler on the Roof.
In Katsenelson’s telling, Tevye needs to buy a cow, so he goes to auction to buy the best one available at the lowest price. First, Tevye needs to know how much the cow is worth: how much milk will it produce over the next five years and how many calves might it birth? Once Tevye has calculated the cash flow for this mythical cow, he can determine the value. For instance, it would be silly to buy a cow for $10,000 that will only produce $7,000 in revenue (including her value at termination), so Tevye, a shrewd buyer of cattle, will look to establish a margin of safety by buying the cow at a discount to its actual price. Once he’s factored in inflation, opportunity cost and the cow’s relative value, Tevye can make an informed and prudent purchase.
That, in a nutshell, is what value investing is all about, according to Katsenelson, chief investment officer at Denver-based Investment Management Associates and author of two books, including The Little Book of Sideways Markets, a guide for investing in our topsy-turvy economy.
“You basically look for companies that you can understand, you figure out how much they’re worth, figure out the discount to the fair value, and that gives you a buy price,” Katsenelson said. “When the companies get to the buy price, you buy them. Otherwise, you just wait.”
Value investing. It’s a topic that brings to mind apple pie, baseball and Warren Buffett. It also can be about as exciting an investing strategy as watching paint dry. For value investors, high-flying IPOs, overvalued tech companies or the hot stock of the moment don’t hold interest. Careful research, due diligence, patience and integrity, on the other hand, do.
The question is, in our present-day “sideways” market, where the peaks of 2007 and the valleys of 2008 were followed by the false expectations of 2010, is value investing the right approach? That is, with price-to-earnings ratios falling on the one hand and corporate America ringing every cent of profit out of their leaner companies on the other, are there still quality companies with great growth prospects at a decent price still to be found?
Yes and no. While Katsenelson and others argue that a value approach is always the best way to value the purchase of stocks, the data show that value investors have taken a beating recently.
According to data provided by Frank Voisin, a value investor whose blog is titled Frankly Speaking, hedge funds taking a fundamental value approach were down 23.6% in 2011, the worst performer of 14 hedge fund categories.
However, over the last decade value stocks have performed better than the wider market. Data supplied by Russell Croft, co-manager of the Croft-Leominster Value Fund (CLVFX), show that Russell Value 1000 stocks returned 3.37% from 2000 through 2011 while the S&P 500 returned just 0.55%. Looking at larger stocks, data from San Francisco-area Equius Partners show that large value stocks as an asset class outperformed large market stocks both in the United States and internationally.
Keeping Steady
David Merkel, a value investor who has come to some renown through his Internet commentary at the Aleph Blog, believes that a value investing approach is always optimal, no matter the market conditions. That said, Merkel carefully reevaluates his portfolio three to four times per year and turns over the majority of his stocks every three years.
For Merkel, value investing is fundamentally about not losing money. The Maryland-based investment professional says that over 20 years as a value investor and approximately 300 stock purchases, he has made money 75% of the time. He doesn’t make a pot of gold, but says he has outperformed market averages. “I focus on companies that have reasonable prospects and not a lot of debt,” Merkel explains. “If you take on stocks that have a lot of risk, yes, you could gain a lot — or you could lose a lot.”
