On the surface, value investing is pretty simple. As a value investor, I want to buy stocks at a discount. I want to look at a company’s price relative to what I think it is worth, and I want to build a basket of stocks where I think that discount is greatest.
In theory, the calculation of what a company is worth is a complicated process that involves projecting its cash flows well into the future and discounting those cash flows back to the present at an appropriate discount rate. But that process is a very challenging one and involves trying to predict and measure things that none of us can, so most value investors revert to some simple rules as a starting point to measure value. Those simple rules typically involve measuring a firm’s market value relative to some representation of its historical fundamentals. For some investors, that can mean valuing a firm relative to its earnings. For others, I can be its cash flows. And for others, it can be its book value. But the one think all of these metrics have in common is that they use what a company has done in the past to help predict its future.
This process of using past fundamentals to try to predict future prices has been in place for a very long time, and there is more academic evidence than I could possibly cover here to support it, but suffice it to say that this process is well supported by historical data.
One of the major challenges of it; however, is what happens when we are confronted with breaking points that are so large that a company’s past results prior to it occurring might tell us very little about what it will look like after. The current situation with COVID-19 might be the most significant situation of this type that any of us will experience in our investing lifetimes.
If I am trying to value an airline right now, how much does their 2019 results tell me about what they will do this year? If an Energy firm can’t pay its debt and ends up bankrupt, does buying it a PE of 2 based on its earnings from last year do me any good? Or should the fact that a retailer whose stores are all currently closed had strong cash flows for the last 5 years mean anything to me? These are the types of questions that all value investors currently have to deal with. We all have to at least ask whether COVID-19 has temporarily broken value investing.
Rather than try to answer this question myself, I will differ to Tobias Carlisle of Acquirer’s Funds who answered the question in the following way in his recent interview on our podcast.
Here is what Toby said:
I don’t know that this is any different than what we (as value investors) always do. We are always buying something in a crisis. Usually it is more specific to the company, but the reason you get this chance to buy is because there is this massive uncertainty. People just don’t know what the next quarter or two will look like. And so for value guys, that’s business as usual.
The point he makes is a really important one. Value investing always involves buying companies with problems. It always involves dealing with the uncertainty that the future will look different than the past. Obviously that level of uncertainty can vary significantly over time and it is probably close to an all-time high right now, but at a high level, what we are dealing with is certainly not unprecedented.
But having said that, I think there are some important things to keep in mind when building a value strategy in a time like this.
Here are a few principles that I think are helpful in building a value portfolio at times of significant stress.
[1] Cash (And the Ability to Get It) is King
By definition, a stock can’t represent a value if the company behind it can’t survive. Value investing always has a high error rate, and many companies you buy as a value investor end up doing poorly. Some even don’t survive. But during a time like this, with many businesses completely or partially shut down, this is especially important. I think any analysis of value stocks right now should include a look at whether the company can survive.
Looking at the number of months a company can operate at zero revenue can a valuable metric to do this, although it can be very difficult to calculate quantitatively because it depends on things like the lines of credit that a company has available to it and the expenses it is able to eliminate or delay. But regardless of how you calculate it, it is important to have confidence that a company can make it through to the other side.
[2] Diversification Takes on Added Importance
It is very tempting during a time like this to double down on individual names and specific industries. When prices fall very quickly for industries like airlines or hotels or cruise lines, it is easy to think that the stocks within them are worthy of aggressive buying. That may end up being the case, but the problems in some of these industries and individual names may also end up being even worse than what is currently priced into the stocks. As a result, diversification takes on an added importance during a time like this.
[3] Consider What a Company Looks Like During More Normal Times
Even though the vast majority of companies will have lower earnings and cash flows after an event like this, it is still important to consider a stock’s valuation relative to something that represents more normal times. If 2019 was within a firm’s normal trajectory, that might be a good place to start, or as Toby suggested in our podcast interview, using an average of earnings over time can work too.
[4] Negative Quality Screens Become More Important
Most quantitative value firms use some sort of system to try to limit value traps. The criteria within these systems can vary, but what they have in common is they try to filter out names with obvious problems. These types of systems can be even more important at a time like this. For example, in our system we look to exclude firms that rank in the bottom 10% of our database using a combination of the following criteria.
- High debt
- Cash flows that are not keeping up with earnings
- Future earnings estimates that are far below past earnings
- Low relative strength
Firms with high debt, earnings that aren’t backed up by cash flows, and earnings that are expected to fall substantially can all be less equipped to make it through something like this. And eliminating the absolute worst performers from a price perspective can help too because sometimes there are major problems that are not reflected in the fundamentals.
The Path Forward for Value
COVID-19 is certainly a crisis unlike any other we have seen. And as a result, it will present its own series of unique challenges for value investors. In many ways, it already has, with many value stocks down significantly more than the market. If you aren’t comfortable investing at times of crisis, value investing may not be for you. But if you believe, like I do, that some of the best opportunities often come in the wake of the biggest crises,
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Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
