Eric Cinnamond: Value Investors Spinning Their Wheels While Suckerfish Get A Free Ride

Johnny HopkinsEric CinnamondLeave a Comment

In their latest Q3 2020 Market Commentary Eric Cinnamond and Jayme Wiggins at Palm Valley Capital provide an interesting analogy of what it’s like to be a value investor while passive and momentum investors get a free ride for little effort. Likening the two groups to remoras, or suckerfish (passive and momentum investors), and sharks (value investors). Here’s an excerpt from the commentary:

Call it sour grapes, but it’s not fun to spin your wheels when you feel like you are investing responsibly, while you watch other investors get rich with much less mental anguish! You can’t put a price on the sense of relief many feel when they abandon their investment principles to join the herd. Actually, you can put a price on it, and it may turn out to be a very costly decision.

There is room for all kinds of investment strategies in the big blue sea, but let’s face it—most investors are remoras. Remoras, also known as suckerfish, attach to a host animal such as a whale, shark, ray, or turtle and remove parasites and loose skin. Like passive and momentum investors, remoras catch a free ride for little effort. They mostly feast on the waste of their host. It’s a symbiotic relationship, since the remora benefits when the host thrives. Remoras live from 2 to 5 years, which, on the long end, is similar to the duration of a typical bull market, at least before the Fed tried to make them permanent.

Value investors are more like sharks. They’re independent and generally not liked. When other investors see them, they move quickly in the other direction. Sharks and value practitioners both prey on the wounded. They prefer a big meal but can get by on scraps. Also, they’ve been around for ages.

Greenland sharks are rumored to survive over 300 years, with one tagged fella supposedly born 400 years ago. He was around to see Tulip Mania and the South Sea Bubble.

While the difference in performance between large growth and small value stocks has been striking, we don’t believe a chart displaying the historical returns of two strategies is adequate to decide on the present investment case. Examining valuations is more instructive. In our view, while megacaps are overpriced, valuations of the biggest companies are not as irrational as they were in 1999. The median Enterprise Value to EBIT multiple of the biggest ten nonfinancial companies is much lower than it was two decades ago.

However, on an unleveraged pre-tax basis, the valuation for the typical large cap company is almost twice as high as it was during the tech bubble. With a median EV/EBIT multiple of 27x for the S&P 500, we’d wager that the average big cap stock has never been this expensive. In our opinion, the overvaluation in today’s market is much broader than it was in 1999, so it’s a far more challenging backdrop for value investors.

The investment story for small caps, and in particular, small cap value stocks, is less clear cut. There is no widely accepted definition of what constitutes a value stock. In fact, hundreds of companies are partially present in both value and growth indexes from leading benchmark providers. In general, growth investors want to own firms with above-average growth, while value investors are primarily concerned with the price they pay. With that said, you’d be hardpressed to find a value investor who would turn away a rapidly growing, attractively priced business. It’s just difficult for value investors to pay up for projected growth.

You can read the entire commentary here:

Palm Valley Capital Management Q3 2020

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