One of my favorite things about value investing is that it is a broad church. A lot of people typically talk about value in generic terms, comparing value stocks to growth stocks. The reality is there are many strategies under the value investing umbrella.In this post, I’ll outline several of the main value investing strategies, give some examples, and discuss which ones I focus on.
Growth at a Reasonable Price (GARP)
GARP investors try to balance buying high growth companies while still maintaining an anchor to business fundamentals. Companies like Tesla, Beyond Meat, Uber, pot stocks, tech companies, are growing their sales at very high rates. Oftentimes, the narrative of their growth is driving the stock price to valuations that would imply unrealistic growth. Additionally many of these companies are not profitable. GARP investors would find high growth stocks that still had a profitable business trading at a reasonable price.
One of the main metrics used to find GARP stocks is the Price to Earnings Growth ratio (PEG). The PEG ratio was made popular by the famous fund manager Peter Lynch. Examples of GARP stocks are Apple (AAPL), Microsoft (MSFT), and Lowe’s (LOW). I don’t utilize this strategy in my investing since I typically focus on more modest growth, and more emphasis on being undervalued.
Quality
Warren Buffet says to “buy great companies at fair prices”, which is the definition of this value strategy. Quality stocks have strong brand names, competitive advantages, constantly growing profits, little debt, high returns on equity, low growth. These are companies like Coca-Cola (KO), Procter & Gamble (PG), and Johnson & Johnson (JNJ). It makes sense to want to invest in high quality stocks, however these companies are typically very expensive. With their predictable earnings, and often recession proof businesses, they are almost treated like bonds. ETFs such as QUAL contain these types of companies, but they appear overvalued for my liking. I would love to own a handful of quality companies at a good price. In reality, the only time you can find remotely cheap quality companies is during a market panic.
Compounders
Compounders are quality businesses with competitive advantages, good return on equity, and modest to high growth. The idea is that these companies will continue reinvesting earnings into their business in order to compound at attractive rates for 10 years or more. In many ways these are similar to GARP and quality stocks. Compounders will have high return on equity and consistently growing earnings. Finding an attractively priced compounder is an investors dream, but difficult to do so in a bull market.
This value investing strategy gets a bad rap from “Compounder Bro’s”. These investors buy companies like TransDigm (TDG), Roper Technologies (ROP), or software-as-a-service (SaaS) stocks, which are great businesses. Compounder Bro’s stereotypically over pay for these stocks, or may have over-optimistic projections of future growth. Additionally, Compounder Bro’s brag about how great their stock picks have done since these types of companies have greatly outperformed typical value stocks lately.
Traditional Value
What I consider traditional value stocks are good or decent companies that are temporarily undervalued. Reasons for their cheapness could be bad news, law suits, sector headwinds, being misunderstood, or the business is out of favor. Usually if the financial media is saying a sector or business is “dead”, then it’s time to sift through the depressed industry and find any hidden gems. These types of stocks are one of my main areas of focus. I typically look for solid businesses with low debt, then try to understand the narrative and decide if the consensus is overreacting.
In my current portfolio, Capital One, Emerson Electric, and Simon Property Group fall into this category. Emerson was simply sold off because of the dramatic March sell off. Capital One has to navigate this low rate environment, which means it’s cheap along with a bunch of other financial stocks. SPG has high quality malls in major metros which I think will do fine, while crappy malls in crappy cities will die.
Another example is in 2017, when all the headlines were saying Amazon is killing retail. Sure, Amazon will destroy companies like Sears and JC Penny who sell undifferentiated products. But retailers like Tractor Supply and Williams-Sonoma got caught up in the industry selloff. I thought these businesses were higher quality, niche retailers that would not immediately be impacted by Amazon. These companies had strong fundamentals but were selling at a discount. I bought both of these companies and sold them a year later for a 40-50% gain.
Quantitative Value
This strategy involves buying a basket of statistically cheap stocks. Out of this basket, some of the stocks will do poorly but hopefully a subset mean-revert to a typical valuation. The valuation metrics used to screen for these stocks could be price-to-book value (P/B), price-to-earnings (P/E), price-to- free cash flow (P/FCF), enterprise value over earnings before interest and tax (EV/EBIT) among others.
Buying low P/B stocks is a classic implementation, is often used in academic value investing papers, and often is used in value indices. Supposedly accounting standards don’t accurately account for book value with tech companies, or businesses with a great brand name. P/B seems to work better for financials or old economy businesses with little R&D or other intangible assets. Given these apparent limitations, I do not screen specifically for low P/B stocks.I like looking at P/FCF in general as a shortcut valuation, however I don’t screen strictly for low P/FCF stocks.
Deep Value
Deep value falls under the quantitative value strategy. The book “Deep Value” by Tobias Carlisle wonderfully discusses this strategy. I wanted to particularly highlight this strategy since I am interested in implementing it in my portfolio. This metric is also known as the acquirer’s multiple because instead of using the stocks market cap (the price), it uses enterprise value.
Enterprise value is the market cap of the equity, plus any outstanding debt, minus cash on the balance sheet. This reflects the price someone would have to pay to buy the entire business since they would have to retire the debt and could use the cash to offset the purchase price. EBIT is basically operating income, which is higher up the income statement than net income (earnings). Net income takes into account a companies interest payment on debt, but this metric factors in debt with the enterprise value.
Studies have shown that EV/EBIT is one of the most robust quantitative valuation metrics. This strategy has historically outperformed the S&P 500. Lately all quant value strategies have underperformed, with value investing in general having a hard time keeping up with the frothy market. I plan on incorporating the acquirers multiple strategy in my portfolio because of its long term track record of outperforming. Another reason I am drawn to this strategy is because it can be rare to find quality stocks at cheap valuations. Low EV/EBIT stocks can fill up my portfolio until opportunity arises.
Asset Plays
Asset plays are similar to buying low P/B stocks, but with a twist. The difference between asset plays, and simply buying cheap P/B stocks, is that the value of the company is based on a physical asset. Occasionally an investor can buy into these assets at attractive prices. If you really dig for treasure, you can find companies where the assets are under reported on the balance sheet, which creates value. An example would be a Maui Land and Pineapple (MLP), that has real estate recorded on its books at the price paid decades ago. Of course Maui real estate has greatly appreciated, but this value is not showing up in the accounting. Another example could be a timber company, or quarry, that owns natural resources. Additionally, these hard assets will probably do well during inflationary periods.
Net-Nets
This is the original value investing strategy devised by Benjamin Graham. While there are a couple of ways to implement this strategy, the most common is to buy companies that are trading below their net current asset value. Current assets are things such as cash, inventory, and accounts receivables. Current liabilities consists of short term debt coming due, and account payables. The net current asset value is arrived by subtracting the current liabilities from the current assets. When the market cap of a stock is below this figure, it is really freaking cheap. You are paying less than the cash on hand and the inventories of the business.
Warren Buffett cut his teeth on net-nets back in the 1950’s, helping him create a great early track record. The problem with net-nets is that everyone knows they are awesome, so it is very rare to find any. Right now there are only a few net-nets that may be worth buying. However, during big market selloffs, net-nets make a reappearance. Finding a handful of net-nets is something I am always on the lookout for.
Special Situations
Special situations, or “work outs” as Buffett called them back in the day, are corporate spinoffs, mergers, or emerging bankruptcies. I think this is one of the coolest value investing strategies. The unfortunately titled book “You Can Be a Stock Market Genius”, by Joel Greenblatt, explains special situations in great detail.
Occasionally companies spinoff operations into a new company in order to simplify the core business, among other reasons. Institutional investors are typically more interested in the parent company, so they indiscriminately sell off their shares of the spinoff. This selling can create tremendous value. Companies emerging from bankruptcy (not going into it like Hertz) can be dirt cheap, and ridden of their burdensome debt. These stocks, under the right circumstances, can provide great returns. I would love to invest more into special situations, however it is time consuming to research these opportunities.
Conclusion
There are probably a few variations of value investing that I missed, but the strategies outlined here are the most commonly discussed. I personally utilize a blend of value strategies. The most desired types of value stocks are probably cheap, quality stocks, and net-nets. In the meantime, I will continue searching for good companies that are misunderstood and share more reliable value investing strategies. Finally, I will use quantitative deep value to round out the portfolio.
Check out my other posts on the fundamentals of value investing:
What Is Value Investing Anyway?
Intro to Discounted Cash Flow Analysis, Part 1