Is Value Investing Still Alive? The Reality of Rerating and Market Patience

During their recent episode, Carlisle, Taylor, and Andrew Wellington discussed Is Value Investing Still Alive? The Reality of Rerating and Market Patience. Here’s an excerpt from the episode:

Tobias: Good stuff. Andrew, David Einhorn says that value is dead in slightly different words. But what do you think about his comments, and what’s your view?

Andrew: Well, one, I don’t think he said it was dead. And if anything, he still is talking about buying cheap stocks. So, we don’t think it’s dead either. I think what his comments were about was how values are not being rerated as quickly as they have been in the past. That sure seems to be the case over the last five years, seven years or so.

The way we invest, we certainly do better when things get rerated faster. That’s a piece of our return. The way we look at things, what I would call the lyrical math, is we want to own companies whose earnings are growing as fast or faster than the S&P 500, but own them at a much lower multiple. And so, if they do achieve growth as fast or faster, then the multiple shouldn’t stay cheap– It should converge with the S&P and drive extra performance.

But as long as the earnings are growing as fast or faster, we can be indefinitely patient, because as long as that spread doesn’t widen, we’re not losing anything. We’re keeping up with the market, maybe even beating it by a tiny bit, if we’re actually getting 1% a year faster growth. So, that’s always what we look for. It enables us to be patient. If you get five points of rerating over three years, that’s better than getting it over seven years, all of them work though. And so, I guess, we’d never had good visibility as to when rerating will happen. If we could figure that out, our returns would be so much higher.

Here I am, year 30 of doing this, and I’m no closer at all to figuring out catalysts. I mean, we could get into another side conversation. The catalysts exist, we just don’t believe they’re forecastable, foreseeable. Any catalyst you could see and count on, it’s already discounted in the price of the stock. So, that doesn’t help.

So, we take this approach of we have both a margin of safety and valuation, but then we also look for this margin of safety and growth rate too. They’re not growth stocks, per se, but again, we want to own something that’s growing– It’s okay if it grows a tiny bit slower than the market. If the market’s growing seven, six is okay. You can still be patient. But you can’t have things growing two or three or four. Because every year now that is delayed, that multiple re rating, you may not make it up in the long run, because you’re losing on the growth rate.

And so, back to the core point. Yeah, it does seem like things are rerating a lot slower. That’s okay as long as we’re not losing on relative multiple. Now, sometimes you do lose on relative multiple. That’s what happened in 2018. But for the most part, if the relative spread stays where it is and you get the growth that’s as good or better than the market, then we can stay indefinitely patient with our stocks and we’ll get paid someday. We just don’t know when.

Tobias: Have you looked at the rerating question? Is that something you can tease out statistically and see if that’s actually the case, or you just think value underperformance illustrates that?

Andrew: Rerating happens at two different levels. There’s idiosyncratic and then there’s a more macro level, which is, what we would call the value cycles, that when value’s out of favor, multiple spreads are widening. And when value is in favor, generally multiple spreads are compressing. So, those are long waves, that happen about once a decade.

And then, even when value’s out of favor– Not every stock is out of favor. You still get strong enough news on individual companies that cause things to be rerated. We have the stock charts of everything we’ve owned. We could see for the ones that have worked exactly when the multiples began to inflect upward.

You can go back and look at all the news that happened right up to that point. We can’t tell any difference from the news then to what the news was one year before that, two years before that. We have perfect hindsight of when these inflection points happen, and we still can’t find, knowing exactly where to look, any evidence of what caused it. So, it still remains like holy grail.

If we could avoid two years of dead money before things worked out, then our returns would be just that much better. But we don’t know how to do that, and so we default to this view that, “Okay, if the earnings double, then the stock should at least double and then the multiple should go up, because it’s too low for a company whose earnings are doubling over five, seven years.”

Earnings growth as the market, but our multiple rises relative to the markets, that always has to work out to outperformance. Sometimes it’s 100 basis points and sometimes it’s the 1,000. Those are all good outcomes, 1,000 is better than 100. But we can’t control that part. So, what it really distills down to, is don’t pay too much and then get the earnings right as much as you can. Get as many right as you can and get as few wrong as you can, and it’ll all take care of itself.

Jake: Can buybacks be part of a catalyst, if you will– Maybe it’s not like an instantaneous, but you can just see the cannibalism– I think Buffett’s, probably a lot of his recent theses have been pretty buyback heavy.

Andrew: There are many ways to get to good earnings growth. Buybacks is a common boost to our earnings growth. So, you talk about, say, 10% per year earnings growth. GDP is not growing that fast. And so, the way you can get to 10% earnings growth though, is if you have a nominal GDP like top line growth. Some companies have some margin expansion, but you can’t do that forever.

But if you’re a low capital-intensive business, high free cash flow business, then most or a lot of those earnings are available at the end of the year to buy back stock. A company that’s got 6% operating income growth may with some financial leverage have 7% or 8% net income growth and then with stock buyback can be more like 12% earnings per share growth. And so, that all goes towards the formula. That’s how you compound at those– It’s one of the most reliable ways that you can compound at those rates.

So, it’s great for earnings growth to have a low capital-intensive business that generates free cash flow that you can buy back stock, and get higher EPS growth and operating income growth. But it’s not a catalyst to make the stock go up today. At best, it seems to be even. I’ve never really seen that be an effective short-term catalyst.

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