What Do We Mean When We Talk About Value?

Dividing the market up into "value stocks" and "growth stocks" has long been common practice in the investment world. But what do these labels really mean? Join Steve Bleiberg as he looks to answer "What is value?" (September 05, 2019) 

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Transcript

Speaker 1: 0:02

Hello, and welcome to Actively Speaking. I'm your host, Steve b Weiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager. Hi everyone, it's Steve here. Thanks for tuning into another episode of Actively Speaking. We at Epic have been thrilled with the feedback we've received from our initial episodes, and we'd love to hear more from you. The listeners, please take the time to rate and review this show. And if you have any questions about active management, investing, capital markets, or any other topics you'd like to share with us, please email us at info eip n y.com. Thank you. And now here's the show. Hi everyone. Welcome to another episode of Actively Speaking. You know, we have a whole bunch of white papers on our website. If you go to it, uh, eip p and y.com. You'll see we have many, many, uh, white papers and insights we've written over the years, and there's quite a few of them that we think are worth talking about on an episode of this podcast. And, uh, some of them are things that I wrote. And so it's, it, it doesn't really lend itself well to, to me being interviewed by somebody else. We figured it's just better for me to just talk about the white paper myself if it's something that I wrote. So, so that's what we're gonna do today. We're gonna do another episode without a guest. And I'm gonna talk about a white paper that I wrote in the, in late 2017. It's called, what Do We Mean When we Talk about Value? And thi this is a really, I think, important topic. Value is a word that gets thrown around a lot in the investment business, but what does it mean when I hear the word value? To me, it has a connotation of you're getting a bargain, you're getting something at a really good price. Uh, in essence, uh, you're, you're paying less than you quote should for, for what that, whatever that item is. But the concept of value is tricky. And let me give you a quick example, uh, using a, a basic commodity milk. So if you go into a store, usually what you'll find is that the price of a gallon of milk is less than four times the price of a quar of milk. Uh, of course there are four quarts in a gallon, but if, uh, so it might be, say that you could get a gallon of milk for$3, but a quart, if you buy a quart, it's a dollar 50. Well, that's, you know, if you buy a quart at a dollar 50, you know you're paying$6 a gallon, uh, whereas you can buy the gallon for$3. So, so it would seem, you know, on, on the surface looks like, ah, you know, a gallon is much better value. On the other hand, what if you don't actually drink milk? You just need, uh, a qut of milk for a recipe for something you're cooking. Uh, in this case, you could pay a dollar 50 and get a quart, or you could pay$3, buy the whole gallon, then be getting a better rate per court, but you're gonna throw away three of the four courts in that gallon. So was that really a good value? So actually value is not necessarily as straightforward as it seems. Let's think about it in terms of stocks. Uh, what, what does it, does it mean to say something is, is a value stock? Well, in the example with milk, we, we talked about you're paying, what are you paying per court? So you're relating the price to some quantity that you're getting for the price. So what's the analogy there, or what's the analog with stocks? Well, most people think, gee, when I buy a stock, here's the price I'm paying. And in terms of what they're getting for that price, what they usually look at is something like earnings or book value. So you have a PE ratio or price to book ratio, and if one stock is trading at 15 times earnings and another is trading at 12 times earnings, the temptation is to say, ah, well, the stock that's trading at 12 times earnings is a value compared to the one that's trading at 15 times earnings. Well, let's think about that. I suppose these two companies both have a dollar per share in earnings. So one of them's trading at$12 per share and one's trading at$15 per share. Uh, so again, the the initial conclusion is, uh, ah, the, the one that's trading at$12 is cheaper. It's better value. Well, what if, what if that dollar per share in earnings for that company, uh, represents a, the fifth straight year of declining earnings? And five years ago earnings were$2 a share, and they've fallen every year by 20 cents, and now they're down to a dollar per share. Whereas the other company, the one that's trading it$15, they also have a dollar per share in earnings right now. But in, in their case, the earnings were 50 cents five years ago, and then they went up, you know, 10 cents every year, say, just to make it easy, uh, and are now at a dollar per share. Very different profiles. Those two companies. Now, you might say, well, hmm, you know, maybe the one that's trading at$12 or 12 times earnings, maybe there's a good reason for that. The earnings have been declining for five years, and the other one at$15 a share looks more expensive on a PE basis. But you know what, the earnings have been rising every year for the last five years. So again, not as straightforward as it seems clearly. Uh, you can't just look at a company's earnings or book value in raw terms and relate the price to that number and, and conclude that that's what constitutes overvalued or undervalued. There's, it's a much more complicated story. But let's step back for a second and just think about the way that the investment business has been divided, uh, for many years now. People talk about value versus growth. That's the kind of standard dichotomy that people use when they're talking about stocks or when they're talking about managers. Investment managers like us, active managers, are often classified as, oh, that person's a value manager, or That person's a growth manager. And I want to talk about that and think about what those words mean. It's become so common. I mean, it's, it's a, again, it's this is the way the world is. This is the way the industry is viewed. And I think because of that, people don't often stop to take a moment to say, wait a minute, does this make sense? Why are we dividing the world this way? If you divided the world into, say, left versus right, that makes sense. Those are opposites or up versus down, those are opposites, but value and growth are not opposites. It really doesn't make sense to divide the world into things that are not complimentary like that, because there's sort of an implication there. If you think about it, if you say, well, something can either be value or growth, so value, again, the the connotation to me is you're getting a bargain. Well, if that's the case, then value should outperform over time. If you're buying things for less than they should be selling at, presumably the market eventually wakes up to that fact and corrects that mistake, and those stocks outperform as, as that undervaluation gets corrected. On the flip side of this, uh, again, we have this word that people use growth. First of all, shouldn't the opposite of value be something called like overpriced or overvalued as opposed to growth? There's an implicit assumption there that anything that's not cheap must be growing fast. Or the flip side of that same assumption is that anything that's growing fast must be overvalued, which really makes no sense that that's not necessarily the case. Something can be growing fast and can still be underpriced with the benefit of hindsight. It can turn out that it was trading at a price that was less than it was worth at, at the market, drove that price up. And something that's trading at a low multiple of earnings might actually still be overpriced. Uh, as I mentioned before, that example where you have a stock whose earnings have been declining every year, it may look cheap on a, a price to earnings basis, but if the earnings keep declining and the company goes outta business, then even paying that$12 a share was too much. So there, there's no reason to believe that value and growth are opposites, and that's something that is, you know, looks cheap, has to not be growing fast, and that something's growing fast must be overpriced. But on top of that, so, so there's a sort of a, a definitional problem to begin with. It, it really doesn't make a lot of sense to divide the world this way, but, so let's, let's take it at, uh, at face value and say, okay, well that's, that's the way people like to look at the world. What do these words mean? What do they imply? What should we observe if, if these words have any, the meaning that is, you know, normally associated with them? Well, as I say, value should outperform. If things are undervalued, that implies that they will outperform. And if something is called growth, the implication there is they should experience faster earnings growth. Then the stocks that are in the, the other side, the value index, well, those are things we can test. We can, you know, we have, uh, several decades worth of data on, uh, in the US there, there's the Russell 1000 value and the Russell 1000 Growth Index. They both go back, uh, to the end of 1978. So actually we just passed 40 years of data on, on the indices at the end of 2018. So we can go back and see. Okay, so how has value performed relative to growth? Has it outperformed? Uh, when you look at the performance of the two indices, uh, obviously one, it's like you could flip a coin and it could land on its edge. They could end up having the exact same return over some period of time. Uh, but if we look all the way back to the end of 1978, so it's been 40 years, and, uh, actually throw in the first seven months of this year, we're recording this in August, so we've got 40 years in seven months. So it, it is true that the value index has generated a slightly higher return than the growth index on accumulative basis over those 40 and a half years. The difference is quite slight. The annualized return for the value index has been 11.9% per year for the growth index has been 11.5% per year. So does that vindicate the idea that the value index is capturing some, a bunch of stocks that are undervalued? Well, that difference in return would imply that there's not that much of a difference to begin with. But if you'll the pattern of return over time, it's quite interesting. Just looking at the total number over 40 years doesn't really tell you much of the story. When you look at how one has performed relative to the other over time, over that span, it's quite revealing because really for the first, I say almost 20 years of the, of the two indices from the end of 1978 to the end of 1998, uh, they generated about the same return. Uh, there was, there wasn't much difference. Uh, value did well at times, growth did better at times. And, and over those first 20 years, it was a wash. Then there was the famous tech and telecom bubble, the end of the nineties and into 2000. And during that time period, the value Index, in fact, underperformed the Growth Index for a few years. And if you had been wicking, if we had done this podcast, uh, at the end of 1999 or early 2000, first of all, we've had to explain what the word podcast means to people. But the point is that at that time, actually, the value index had underperformed the Growth index on accumulative basis since inception, over a period of more than 20 years, uh, value had underperformed, then of course the tech at Telecom bubble collapsed and value came roaring back in 2001, 2002, and pulled ahead again on a cumulative basis from inception. So there was this period, uh, literally of, of just about a year or two where there was this massive outperformance by the value index as a lot of the tech stocks cratered. Uh, then you had a couple of years in the mid two thousands leading up to the financial crisis where value continued to outperform. And for reasons we'll get into, we'll come back to in a little bit, the value index is much more heavily exposed to, uh, banks and, uh, banks were doing quite well in the stock market in, you know, 2000 4, 5, 6, they seemed to be, uh, you know, generating lots of profit as we discovered after the financial crisis, a lot of that profit was sort of ephemeral or had never really been there to begin with, and had to be written off because it was coming from, uh, you know, investments, insecurities that turned out not to be worth what people thought they were worth. And in, in the aftermath of the financial crisis, banks performed very poorly. And the value Index has been underperforming. The, the Growth Index for over 10 years now, and has brought us back to the point where, again, on a over 40 year basis, the difference in cumulative return is very slight between the two. So the outperformance that that value has created relative to growth over those 40 years was all concentrated in a very short period of a few years. And if this was a more of a systematic thing where oh, value really captures some systematic undervaluation in the names that are in that index, you would not expect to see that kind of pattern. You'd expect to see something much more consistent, not something that relies on a two or three year window within a 40 year timeframe to generate the outperformance. And in fact, if you look at the individual years, you know, so we've had 20 calendar years since the inception of the indices, and it turns out that value has outperformed in 20 of those 40 years, and growth has outperformed in 20 of those 40 years. If you look on a rolling five year basis, growth has actually generated, uh, a slightly a higher return in 50.7% of the rolling five year periods, uh, doing this monthly, uh, updating the rolling five years every month. Uh, so as I said, growth has outperformed in 50.7%, and value has outperformed in 49.3%. So, you know, there's no consistent outperformance of value versus growth. Yes, on a cumulative basis, it's a little bit ahead. It was all concentrated in a short period and on, when you look at rolling one rolling five years, there's just no systematic outperformance by value. So, uh, this, this, the billing of the index quote as value is kind of misleading. It does not, in fact lead to better performance. Okay, so let's talk about the growth index now. Uh, again, the name implies that these are companies that are experiencing faster earnings growth. Well, again, we have data on earnings for the two indices for value and growth. We don't have it all the way back to the inception of the indices. Y you know, people have to calculate the, the, uh, earnings, uh, on, on for the index as a whole. And, uh, the, the data source that we use, uh, only goes back to, uh, the early and mid nineties for that. So we don't have the full data history on, on growth, but, uh, we do have quite a bit of time, and we can look at the cumulative same as we did for performance. We can look at both the cumulative earnings growth for the two indices, and then we can look at the consistency on a rolling five year basis. So it's, it's a very similar story to what we saw with performance on a cumulative basis from Inception. It is actually true that the Growth Index has had cumulatively better earnings growth than the Value Index, but again, it's concentrated in a short period of time. In this case, it's not, it's not really the Tech telecom bubble, the earnings, I mean, part of the problem was that the prices went up so much, but the earnings didn't really outperformed that much. That's why it was a bubble, and the prices eventually came crashing down, but there wasn't a huge differentiation in earnings during that period between growth and value. But where there was, was after the financial crisis, again, as I said a moment ago, the value index is much more heavily exposed to financials. Financials. So their earnings collapse, you know, in some cases go strongly negative in 2009. And so the, the relative, uh, growth and earnings for the Growth Index versus the Value index spiked up really sharply in 2009. Uh, but it came back down, not all the way down, but it, it came back down in, in from, say 2010 through 2013. It's been doing a little bit better again in the last few years, not dramatically so, but on a cumulative basis. Yeah, so the earnings Growth for Growth Index has been a little bit higher than the Value index, but like I said before, just as there were times well into the history of the indices where actually growth had outperformed value, similarly, had you looked on a, a cumulative basis in 2007, you would've said, gee, actually the Value Index has had better earnings growth, uh, than the, the growth index, uh, from the beginning of the data in, in 95. Uh, but they gave it all back in the financial crisis. And, and now we're at a point where cumulatively, again, growth Index is ahead. But same thing, when you look on a rolling five year basis, it's an even split. Uh, the Growth Index is had better five year earnings growth, 50.6% of the time, and the Value Index has had better earnings growth 49.4% of the time. There's just really no difference, uh, in earnings growth between the two on in terms of raw numbers. What's interesting is that the earnings for the Growth index are actually less volatile than the earnings for the value index, which might be the opposite of what you'd think. You know, you'd think, uh, the thing about value stocks is, oh, you know, they've got earnings and they're just cheaply priced, uh, whereas growth stocks are these high flying things, but sometimes earnings collapse. Well, it's the opposite, actually. Like I said, you know, it's, it's really driven by what happened in the lead up to, and then the aftermath of the financial crisis in the early two thousands is that the earnings for the value index seem to be soaring in, in 2000 4, 5, 6, and then just collapsed in eight and nine. So the, the result is that actually the earnings for the growth index have been less variable as volatile than the earnings for the value index. Okay, so where does this leave us? Uh, we've seen that value doesn't mean likely to outperform, and growth doesn't seem to mean experiences faster earnings growth. So what do they mean? What do these words mean? How are these two indices created? We need to look into that. And what you find is that the way that, well, Russell in particular divides stocks into its two indices. The, the growth and value indices within the Russell 1000 is they use one valuation measure, which is price to book ratio. Uh, they also use a couple of growth indicators. One's looked backward. It's it's five year growth in sales per share, and there's a four licking variable, which is expected earnings growth from Ibes over the next two years. So they combine these three things into a single score, but again, there's only one valuation variable. It's priced to book. So not surprisingly, if you sort things based on price to book, what you find is the value index always has a lower price to book ratio than the growth index. Um, question is, does that mean, is that meaningful? Does, uh, well, we've seen that. It doesn't seem to mean, you know, the value index doesn't systematically outperform with any consistency. So what's really going on here? Well, priced a book is usually quite hardly correlated with return on equity, which makes, you know, perfect sense, because when we say return on equity, the, the equity there is the book value. So if you say, well, companies that earn a higher return on their book value will tend to trade at higher multiples of their book value, that's really not much of a surprise. The question is, is it insightful? Does it tell us anything? You know, if you step back for a second and say you'd, you expect the value index to outperform, uh, and yet you expect the Growth Index to have higher earnings growth, you know, that makes no sense. Why would you expect companies with worse earnings growth to outperform companies with better earnings growth? So the whole premise doesn't really make sense to begin with about dividing the world that way, uh, into earnings, uh, value and growth. But specifically the way it's really done is not so much on, on pe, it's on price to book. Um, and again, you're just a, a low, A value index is basically a collection of companies with low return on equity. And that is, in fact, one of the reasons why, coming back to the point I said, we would come back to, why is the value index so full of, uh, financial stocks? Well, because they tend to have low return on equity, and they tend to therefore trade at low price to book multiples. And so that's why you get this, you know, something like a 25% weight or sometimes even higher in financial stocks in the value index, uh, versus a low single digit weight or mid single digit weight in the growth index for financial. So, you know, these indices are capturing something that's really not some sort of pure value effect. Uh, it's, it's heavily driven by certain sectors, and it's, uh, that's a direct outcome of the fact that certain industries just have lower returns on equity, therefore they trade at lower price to book multiples. So to, to believe that one is gonna systematically outperform the other is really just boils down to saying, well, I think these sectors are gonna always outperform those sectors. So I would argue it's not that useful a distinction, uh, to divide the world that way. Is there a better definition of value? Well, if you read, uh, we have a number of white papers that keep coming back to this theme. In recent years, uh, there was a white paper we had called Free Cash Flow Works. Uh, there's a more recent white paper just a few months ago called PE Ratio, a User's manual, and that's a, those two combined with this one on, uh, what do we mean when we talk about value? They're all kind of circling around the same subject, which is what is the, the real metric? What is the best metric of value? And our belief at Epic is that it really boils down to free cash flow yield. If you go, if you're gonna go buy a business, uh, you wouldn't really care that much about the book value. You wouldn't care that much about the accounting earnings because accounting earnings are, you know, they don't necessarily tell you what cash the business is generating. They're, uh, very distorted by things like accruals, like, uh, or the way depreciation is handled. If you were gonna buy the business a hundred percent and you were just gonna own it, what you would want to know is at the end of the year, how much cash is gonna be left for me, the owner, uh, to take out of the business versus, and, and that's what you would put relative to what you're paying for the business. And if you say, well, gee, I'm paying, you know, uh, a hundred dollars to keep the numbers very simple and it's gonna result in, uh, 10% or, or$5, say$5 in my, uh, pocket at the end of the year in cash, that's a 5% free cash flow yield, uh, on my a hundred dollars investment. That's the way you would evaluate it. Uh, you know, even if the earnings were$12, well, but if it's really only$5 in cash, what good are those$12 in earnings to you? Uh, that that's not how you would really think about, you know, what you're getting for what you're paying. You'd wanna look at the free cash flow yield. And so you can, in fact, sort stocks just as you can sort them on price to book or return on equity, you can sort them, uh, into their free cash flow yields. And we've done that here at Epic. And, uh, the last part of the white paper, uh, shows a analysis of the performance over the years of, uh, dividing the universe. So we used the, um, the Russell 1000 Universe and divided it into Quintiles, uh, so fifths, uh, based on free cash flow yields and looked at the performance, uh, going, and this goes all the way back to 1990. And we found that over time, you know, the top quintile of free cash flow yields, uh, has, has outperformed the market, and it's done so with much greater consistency, uh, than than anything you, you see in those value versus growth indices. Similarly, the, the lowest quintile, uh, free cash flow yield has underperformed dramatically over time. And when we look at the rolling five year windows like we did with the value versus growth, it's much more consistent actually, the, with the value growth, the, the world is being divided in half. We, we did it with Quintiles, but what we did was we took the top two quintiles and combined them, and we took the bottom two quintiles and combined them. So we're covering 80% of the universe and divided to get it into two groups. We left the, the third quintile Oklahoma in the middle there, and actually on a rolling five year basis, the, the, the top two quintiles have, have literally always outperformed the bottom two quintiles on a rolling five year basis, not always by a huge margin, uh, but it's, the gap has always been in favor of the top, uh, the, the chi free cash flow yielding companies relative to the lower free cash in the companies. So if you're gonna talk about value, the right way to talk about it is to think about free cash flow yields and the indices that people rely on. And the, the whole definition that people use to just differentiate between managers too about value versus growth is just very problematic. Uh, as I said at the beginning, those words are not opposites. It, it doesn't really make a lot of sense to divide the world into two buckets where the buckets are not really complimentary. Uh, number one, and number two, when we test them empirically, we find that the definitions on the surface definitions of value and growth don't really hold up that the, the value index has not consistently outperformed the growth index. And similarly, the earnings growth for the growth index has not been, been systematically higher than the growth of the value index. So it's a, it's an uphill battle to get people to, to agree with us on this, but we just wanted to lay that argument out there and make the argument for focusing on free cash flow yields, uh, as opposed to traditional definitions of value that rely on PE or price to book. So thanks for listening and we'll talk to you again soon. Remember to subscribe to actively speaking on Apple Podcast, Spotify, or Google Play. You can find all of our previous episodes and additional content on our website, www.eipny.com.

Speaker 2: 24:24

The information contained in this podcast is distributed for informational purposes only, and should not be considered investment advice or recommendation of any particular security strategy or investment. Product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but is subject to change any performance information. Reference in this podcast represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this podcast are forward-looking statements and are based on epic's research, analysis, and assumptions made by Epic. There can be no assurances that such projections, targets or estimates will occur, and the actual results may materially be different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the returns or performance of any accounts and or funds managed by Epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable. You cannot invest directly in an index, which also does not take into account trading commissions and costs.

Speaker 3: 25:51

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