Making the case for long-term value investing — again
A new book by Jim Cullen, founder of New York-based Schafer Cullen Capital Management, restates the case for classic value investment principles
Over the past decade as — until very recently — growth stocks have surged ahead, the financial press has conducted regular post-mortems for value investing, an investment strategy deemed to be terminally out of fashion.
It might be more interesting, however, to ask whether it has ever actually been in fashion. Taking the time to research shares, in unglamorous market sectors, that may or may not be undervalued, and waiting for years for them to come good lacks the thrill of riding the momentum stocks promising to change the world: the green energy start-ups at the edge of the energy transition; the blockchain innovators promising to reinvent money; the biotechs on the cusp of gene-editing breakthroughs; the tech firms exploring the metaverse; or the cannabis retailers aspiring to tap vast new consumer markets.
The Case for Long-Term Value Investing, a new book by Jim Cullen, founder of New York-based Schafer Cullen Capital Management, is intended as a bracing corrective, offering a plain-spoken, unapologetic defence of classic value investment principles. The book’s simple cover design — black uppercase text on a plain yellow background — and unvarnished prose underline the back-to-basics philosophy. The argument is presented over 272 generously spaced pages that can be read in a couple of evenings — indeed the book could have been briefer still. But Cullen’s case, backed with a battery of charts, graphs and data tables, has an understated power.
His particular take on the value philosophy — there are a few schools — is based on the later thought of Benjamin Graham, whose seminal books Security Analysis (1934) and The Intelligent Investor (1949) retain their canonical status. The strategy set out in the book follows the simple principles set out in Graham’s final interview, given in 1975.
In brief, investors should choose securities according to three disciplines: their price-to-earnings and price-to-book rankings, and their dividend yield. Rather than overpaying for growth buyers should look for promising price-to-earnings and price-to-book stocks in the bottom 20% of the index, and in the top 20% when ranked by dividend yield. Then they should simply put as much money into them as they can afford and stay in the market, persevering through thick and thin. And they should do so as soon as possible — there is never a right time to buy. Graham was interviewed when Wall Street was struggling to recover from the 1973–1974 recession, the worst since the 1930s, with stocks down 50% on their highs. For him value investment was as much a psychological as an intellectual discipline.
Value wins in the end
The book’s most essential chapters set out Graham’s case in plain language, and back it up with potent facts of figures. To cut to the chase, over the past 50 years, from 1968–2020, stocks in all three of Graham’s categories outperformed the S&P 500. Against an annual average rise in the market index of 10.3%, the bottom 20pc by P/E rose by 14.6%, the bottom 20% by P/Bk by 13.9%, and the top 20% by dividend yield by 12.4pc.
But value’s robust long-term performance is obscured by the market’s often wild swings from year-to-year. For Cullen the investment industry is much too concerned with short-term performance over one, two, three or even four years. A well thought out value strategy will only begin to show its relative worth when assessed over a period of at least five years. If the performance of the cheapest 20% of stocks by P/E is viewed in terms of five-year periods the inherent pattern — and strength — of the value philosophy is revealed: a difficult five-year period is always followed by an extremely strong period.
The rationale is simple. Because company earnings tend to double approximately every ten years value stocks to tend to make up for flat performance in a given period with a strong performance over the next one. For example value stocks fell by 0.9% during the 1969–1973 downturn but surged 21.1% from 1974–79. A meagre 0.4% rise through 1970–74 was followed by a 30.7% rise over the subsequent period. And a 0.2% rise through 2004–2008 was succeeded by a 25.3% recovery from 2009–2013.
For value investors this cycle is a feature not a bug. One must keep the faith through fallow periods sure in the knowledge that stock prices will follow rising earnings, as day follows night. Since 1940 corporate earnings have grown steadily despite 13 recessions. Indeed dividend yields rise even through the recessions themselves. Ultimately faith in the value strategy is faith in capitalism’s continued capacity to generate growth.
For Cullen, periodic speculation about ‘the death of value’ arises because each new generation of investors and analysts is seduced by the present, overlooking the pattern of market returns over the long term. Growth and momentum shares can ride sustained waves of spectacular growth. Value shares can spend long periods in the doldrums. It happened during the 1960s when Xerox, IBM and Eastman Kodak and other ‘Nifty Fifty’ stocks surged. It happened during the 1990s dotcom boom. And Cullen believes it is happening now, as big tech stocks such as Facebook, Amazon, Google, Tesla, Microsoft and Apple have their day. In the short term value shares struggle in the shadow of a host of competing financial asset classes, including growth, quality, bonds, small cap, international markets and emerging markets. Value has come out top in only two of the past 20 years.
But, given time, the value class wins out. Over the past 50 years, for example, value has comfortably beaten growth. From 1968 to 2020 the bottom 20% of S&P 500 stocks on a P/E basis have beaten the top 20% on a P/E basis by 15.43% to 9.43%. The average outperformance over five year periods was 7.15%. Growth stocks flare and fade, suffering steep downsides when they finally roll over. Value may trail growth for significant periods, but more modestly than growth trails value when growth goes out of favour. Growth strategies depend on the stellar performance on a few high-multiple stocks. The 1960s bull run ended when the performance of the Nifty Fifty, which accounted for 23.1% of total market cap, fell away. The Tech Bubble burst when the internet stocks that accounted for 18% of the market’s value collapsed. And Cullen believes today’s market is again placing too much store on the performance of the handful of big tech stocks that in 2020 accounted for 21.5% of S&P 500 index.
The siren’s call of market timing
Cullen also makes a forceful case for Graham’s other rule: to avoid the temptation to time the market by adopting other strategies or shifting to cash when the going gets tough. The book includes a brief history of securities dating back to the 1929 crash intended to make clear the nature of beast investors are dealing with, a market in which the long term trend is inexorably up, but which is continually disrupted by bear markets, recessions, speculative bubbles, record debt levels, collapses in consumer confidence, interest rates hikes, foreign currency runs, and wars. If investors can look at the big picture they will see that, turbulence not withstanding, the market actually rises about 75% of the time, and the bounce back from down periods tends to be very swift.
Those tempted to move in and out of the market risk missing out on the big bounces that make it worthwhile being in equities at all. Cullen cites a couple of studies reviewing the market through the 30 years to 1991. A Prudential analysis found that equities returned three times more than bonds or the inflation rate over the period, but those gains would have been completely wiped out if an investor had been out of the market for just 10 of the key one-month periods of the 360 months covered. A Templeton Funds study looking at the same period showed there is no ‘best time’ to get into the stocks. Those fortunate enough to invest at a market low achieved annual returns only 1% higher than those who invested at a market high. Cullen likes an observation by Peter Lynch, manager of the successful Fidelity Magellan Fund through the 1980s and 1990s: ‘From one year to the next, the stock market is a coin flip; it can go up or down. The real money in stocks is made in the third, fourth and fifth year of your investment because you are participating in a company’s earnings, which grow over time.’
Having picked good value stocks investors should hold on to them. But portfolios must be kept under review. Cullen doesn’t believe there is any magic formula that can reveal when to sell: investors should simply look out for stocks that look better value than those they already hold. And they shouldn’t have to do that often if they have exercised due diligence in picking their initial holdings. Investors might also consider taking some gains when a surge in the value of a particular stock gives it a significantly higher weighting in a portfolio.
Having set out the fundamental case for picking value stocks Cullen offers a few pointers for selecting them. He suggests an adequately diversified portfolio should have around 30 to 35 equally weighted securities, with no more than 15% allocated to any one industry. Investors should look for shares selling at a 20% to 50% discount to the P/E of the overall market, and offering a dividend yield of 3% or higher. He also keeps faith with the third of Graham’s screening disciplines, price-to-book value, though concedes it is more difficult to assess promising shares in this category, and getting harder. Companies principally based on brand have always been hard to evaluate, and are much more common today — perhaps the majority of stocks. But he still thinks book value is the best discipline for assessing companies in sectors like airlines, metals, and energy. Investors should look out for securities selling at no more than two times book value.
Other stock picking criteria include debt-equity-ratio — companies that have a debt/equity ratio of less than 50% are generally preferred — and return on capital: Cullen suggests a rate of at least 10%. Investors should go beyond the headlines to look out for stocks with good narratives that are not immediately apparent — Cullen’s fund has ridden winners like PetroChina, Diageo, Disney and Unilever — and research management as thoroughly as possible. Substantial stock holdings among executives is a good sign of commitment.
He goes on to suggest how the essential principles he has outlined can serve as the basis for a variety of strategies. Unsurprisingly he highlights Schafer Cullen’s flagship High Dividend Value fund, which adds a dividend component to the P/E discipline to provide additional downside protection. More adventurous investors might seek to supercharge value strategies by orienting them towards small caps, defined by Cullen as stocks that generally have a market cap of $3bn. They may be volatile, but, once again, a long term view proves their worth: since 1968 the smallest 20% of stocks by market cap in the S&P 500 have outperformed the market, returning a compound annualised return of 14.6% against 10.1% for the index. Further spice can be added by selecting good international and emerging markets stocks often dramatically cheaper than their US equivalents.
Must the future follow the past?
Cullen’s book is written from Olympian heights from which the fierce debate that has raged over the continued worth of the value strategy over the past few years is scarcely visible. The performance of the Russell 3000 Value index over the past decade, for example, the broadest measure of value stocks in the US, has solely tested the resolve of even true believers, returning 80% against more than 150% for the S&P 500 index. Growth stocks returned more than 240% over the same period.
As noted, Cullen’s discussion of book value does make some reference to contemporary market trends. The concentration of intellectual property rights and dominant market positioning enjoyed by many of the new technology companies, for example, simply doesn’t show up on balance sheets in the same way as hard, tangible assets. It also seems that the big tech firms, and those in some other sectors, are becoming oligopolies able — in the absence of state intervention — to secure a lock on extraordinary profit margins and relentless growth. Do the Nifty Fifty and dotcom stocks cited by Cullen really bear comparison with contemporary giants — Apple, Amazon, Google, Microsoft et al — that have been able to exploit the digital economy’s inherent tendency to monopoly?
And faith in the art of value investing — the careful curation of undervalued stocks with potential — has been weakened by the rise of passive investment. Value index-tracking ETFs have struggled to keep pace with passive funds tracking the broader US market. A $10,000 investment in Vanguard’s VTV fund, the world’s largest value ETF, would have climbed to $37,281 during the 2010s, but a $10,000 investment in the Vanguard S&P 500 ETF would have risen to $46,426 over the same period.
And passive value funds have been beating their actively managed counterparts. The majority of US value fund managers have failed to beat a passive value-stock benchmark over the past decade. Some 86% of large cap US mutual funds failed to beat the S&P 500 value index during the 2010s, and managers of US small cap value funds did worse, nearly all underperforming the S&P small cap 600 value index. Investors are increasingly preferring low-cost exchange traded funds that track a broad index: at the time of writing some 165 value ETFs are available, managing combined assets of nearly $400bn.
Many investors, then, are concluding that they may be better off simply putting their money in index funds that track all shares — growth, quality, momentum and value — than taking the risk that value might reassert its historic pattern of long-term outperformance. Perhaps there is no iron law that value will always turn out better after all. The future doesn’t have to follow the past.
Here to stay — in some form
But the faith among true believers that value will come good again has been at least partly vindicated since economies began to move past the pandemic, rehabilitating sectors that had been hammered during lockdowns. And tech stocks have continued to fall back as economic conditions have become tougher, with inflation persisting, commodity prices surging, and the threat of meaningfully higher interest rates.
The turning of the tide has been nicely symbolised by the dramatic downturn in speculative growth funds like Cathie Wood’s flagship ARK Innovation ETF and simultaneous recovery of Warren Buffet’s value-driven Berkshire Hathaway, which had underperformed the market for several years. ARK fell 43% through 2021 while Berkshire picked up by 34%. For value advocates like Bob Wyckoff, a managing director of money manager Tweedy Browne, ‘asking whether value is still relevant is like asking whether Shakespeare is still relevant. It’s all about human nature.’ Good value stocks must rise as the market recognises their worth, just as it has always done.
We don’t yet know whether the value strategy will reassert itself in quite the same way as it has done in the past. We need the perspective of time. Cullen’s book uses that perspective skilfully to remind us that stock market history — so far- has a long term bias towards value. His argument is perhaps too blunt, scarcely discussing important developments like the rise of index funds and tech giants that have a seeming lock on the digital economy. But his fundamental case, that value stocks will come good again because they must, is undeniable. The question investors will want to ask is — how good?