Financial Sense Newshour had the honor of speaking with legendary value investor Jean-Marie Eveillard, Senior Advisor to First Eagle Investment Management, to discuss why value investing works over the long haul and how rarely it is used in today's markets.
Given current market valuations and the record high amounts of leverage used by investors to buy at these levels, not surprisingly, Eveillard said there's not much to be excited about right now.
Foundations of Value Investing
We’re in a very unusual period, Eveillard stated. With over 50 years in investment management, he thinks the best question to ask right now is, are we still in the post-World War II economic and financial landscape, or are we in a different, undefined and possibly threatening landscape?
Eveillard’s approach isn’t to try to peer into a crystal ball to find immediate answers, but evaluate the landscape in the fashion value investors have used for a long time. Whenever Ben Graham, the founder of the value school, was asked what will happen to the economy or markets, he would to say, “The future is uncertain.”
Instead, value investors traditionally take a bottom-up approach, Eveillard said, evaluating companies to find intrinsic value, and then comparing that value to the current market price.
On that note, a well-known investment management firm called GMO recently ran Benjamin Graham's "deep value screen" and compared the number of stocks appearing today vs. 2008. Note: not a single stock showed up for the US.
Here's what they wrote in The S&P 500 - Just Say No
An alternative measure of the scale of the opportunity set is afforded by using a screen developed by Ben Graham. He suggested a deep value screen based on four criteria: 1) the stock’s earnings yield should be at least twice the AAA bond yield; 2) the stock’s dividend yield should be at least two-thirds of the AAA bond yield; 3) the issue should have total debt of less than two-thirds the tangible book value; and 4) the stock should have a Graham and Dodd P/E (price divided by 10-year earnings) of less than 16x.
Exhibit 7 shows the results of running this screen across a variety of markets at two points in time: late 2008 and today. In late 2008, the screen was finding lots of cheap stocks – 20% of Japan and the Asian markets were passing the screen; 10% of stocks in the UK and Europe were “deep value” cheap; and, even in the US, 5% of stocks were being thrown up as deep value (including the likes of Microsoft!). Now, fast forward to today. In Japan and Asia only around 5% of stocks are showing up as extremely cheap; in Europe and the UK the number drops to 1% to 2%; in the US not a single stock passes the screen. Not one single solitary stock can be called deep value. [Emphasis added]
While the value approach has worked for Eveillard and many others, including Graham and Warren Buffet, it’s estimated that value investors make up only 5 percent of all managed money, Eveillard told listeners.
If value investing makes sense and works over time, the question then is, why are there so few value investors around now? Ultimately, it boils down to psychology.
“If you’re a value investor, you’re a long-term investor,” Eveillard said. “Ben Graham used to say that in the short term, the stock market is a voting machine, and it is market psychology that prevails. Long-term, it’s a weighing machine that weighs the realities of businesses.”
Chasing What’s Hot
Investment media tends to focus on the short-term and market psychology dominates. But nobody’s smart enough to figure it out on a consistent, repeatable basis, Eveillard noted.
Things are somewhat different this time, in that value investors have traditionally focused purely from the bottom-up and ignored the top-down dynamics of the economy, central bank intervention, interest rates, inflation or other factors.
We’ve seen extraordinary stimulus and a 25-year-long credit boom, Eveillard noted. While central banks may have managed to stabilize matters in the short term, in the process they may have compromised the long term.
“Milton Friedman used to say, ‘I have never been pro-business. I’m pro-free market,’” Eveillard said. “Milton Friedman also said that the capitalist system, the free enterprise system, is a system of gains and losses. For the system to operate properly, the loses are as important as the gains.”
This probably isn’t a sustainable state of affairs, Eveillard stated, and our current system of crony capitalism isn’t a good thing.
The Value Investor’s Approach
Those seeking value are looking at the long-term vis-à-vis the short term. Value investors do want a margin of safety in the form of unrecognized value when they buy a stock, Eveillard noted, but even with loses, sometimes it’s simply better to hold the stock.
“In a sense, the margin of safety lies in the discount to the intrinsic value,” he said. “But it also lies in whether one was right to believe that the business has a sustainable competitive advantage or not. It’s true that some business models change over time.”
There’s not a lot he’s excited about right now in our current market, he added.
While value investors may miss out on some upside and keep exposure during downturns, they dodge another bullet frequent traders often ignore: fees and taxes from trading.
Given that capital gains and income taxes can eat up a large percentage of gains, Eveillard stated, it’s curious that more people don’t try to emulate Warren Buffet.
