Derating and Lack of Rerating Are Changing the Face of Value Investing

During their recent episode, Taylor, Carlisle, and Matthew Fine discussed Derating and Lack of Rerating Are Changing the Face of Value Investing. Here’s an excerpt from the episode:

Tobias: This is a related question, but I tend to agree that if everything gets too cheap and all the competition for investing in this sector goes away, then you should– It’s not an iron law, but it’s an emergent effect of markets, so that’s where you get all of the returns that you get outsized returns if there’s nobody hunting around in super cheap stocks, because the companies themselves should be able to earn and perform.

David Einhorn has been a little bit vocal about this, talking about, the two sources of return are essentially reinvestment in the business and the flows that you get, the capital returns, buybacks, and dividends, whatever else it might be. And he said he was focusing more on the capital returns, because the market wasn’t giving any credit for reinvestment. That certainly seems to be the case, if you look across many of these portfolios you see, compressing multiples, book earnings, cash flows, whatever the case may be. I think that’s one of the topics that you addressed too. You looked at reinvestment versus capital returns. Do you want to talk about that a little bit?

Matthew: I do. Before I get into that, David has said one of the most insightful and thought-provoking things I’ve heard in my career. Recently, he was asked– I guess it’s maybe a year and a half ago or so at this point, so maybe not that recent. But he was asked when value investing comes back, and if your viewers have not heard that, he said it at a Robinhood event and you can find the original version. But basically, what he was saying is that in the old days– This mirrors my experience so closely is why it resonated with me.

But in the old days, you used to find some diamond in the rough. It would be cheap and bombed out. But you would see that the business quality was higher than other people. In your estimation and your judgment, you would buy it very cheaply, the business would perform, and eventually, other people would come in and see that it was a pretty good business and rerate the business.

So, you would get two pieces of return to your point. One is, the value being created from the operations of the business, and then you get the rerating and then you get a really good investment outcome, if that’s the case. But his point was value investing may never come back, because that rerating is not happening, because there aren’t young people coming into this industry. It’s becoming less competitive, not more competitive. So, there’s nobody coming to rerate your business.

To my point, everybody’s getting redeemed, the capital base is shrinking. That rerating phenomenon is not happening. You can actually see that in that S&P, PE spread chart. The rerating is just not happening. In fact, it’s derating still. So, I thought that was so insightful. His approach has been to focus on companies that are returning a lot of capital to you, because you’re not getting that credit for reinvestment and you’re not getting that rerating.

I like that approach. I’m not sure as maybe you heard a minute ago, I’m as cynical about value never coming back. I do still think that it is a cycle. I remember being here in 1999 when it was a very sleepy place and probably very undesirable place to work. Five years later, there was a stack of Ivy league MBA resumes [Jake laughs] waiting at the door for people to–

Jake: Yeah. That’s how you know it’s going to stop working here at any moment.

[laughter]

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