Value Investing – an update
In June this year, Warren Buffett made a deal to provide financing to Canada’s Home Capital Group (HCG) and also purchased a stake in the company. While other investors were selling out of Home Capital because of a run on deposits in Canada’s number one lender of residential mortgages to borrowers with poor credit ratings, Buffett was buying in. He secured generous terms on his loan and purchased his stake at a steep discount of 33% on the stock’s previous closing share price. Time will tell if Buffett’s investment will be successful, for now, this appears to be a good example of Buffett buying cheaply or in other words, a good “value” investment.
Value investing is where the investor buys a stock at a price which is cheap or relatively inexpensive. One of the most common measures of value is the price-to-book-ratio of a stock. As a general rule, if the stock price (or market capitalisation) of the stock is a low multiple of the book value of the company’s assets, then the stock may represent good value to purchase. Often the stock has suffered some event which has resulted in its share price falling. In the case of Home Capital Group it suffered an exodus of deposits following an allegation of mortgage fraud by the Canadian securities regulator.
Value style investing, using diversified funds, has delivered higher returns than the market and its opposite style of investing in “growth stocks” over the long term. The graph linked here shows the performance of value, the market and growth in the US as represented by the Russell 1000 indices. This outperformance is known as the “value premium”.
However, value investing doesn’t always beat the market or growth stocks. In the US, value has lagged and underperformed growth stocks for over a decade (to August 2017). While all investment styles or factors go through cycles of relative under or over performance, questions are being asked about why value has disappointed over this time period. One of the possible explanations is that corporate profits and earnings have increased substantially while interest rates have declined and stayed at historically low levels over this period. These two events have pushed up stock prices as company values are based on the cash that they generate and by the interest rates used to discount future cash receipts. These two events may explain why value investing has struggled relative to growth.
As we know, it is very difficult to predict what the markets will do. Equally, it is difficult to anticipate when value may begin to outperform the market and growth again. However, over the long term the value premium is well documented and rewards longer term, patient investors. As the chart linked here shows, over longer periods such as 15 years, value beats growth 97% of the time. Over shorter time periods, value beats growth less of the time; however these performance figures are still good. As long term investors, we believe it makes sense to continue to allocate a portion of our clients’ equity investments to value funds, while also diversifying across the broad equity market and small caps.
Returning to Warren Buffett, it was recently revealed that he made a gain of $12bn on a deal he struck with Bank of America when the bank was struggling in 2011. At the time, the bank was struggling with legal issues after the subprime mortgage crisis and Buffett came to the rescue and provided finance. A nice profit; and another example of buying cheaply and making a good (value) investment.