Five Questions: Defending Value Investing with Tobias Carlisle

As those who read my articles know, I am a big believer in value investing. But I also understand that as a follower of value, I am prone to focusing on information that supports that belief. A while back, I tried to combat my own confirmation bias by writing an article that looked at the arguments against value investing. That article ended up being the most read article of all time on our blog. So either people liked the concept or they just hate value (hopefully it is the former).

Even though I think the arguments I made in the article do hold merit, I also believe that there are answers to them. I still believe that value investing does work.

I wanted to write another article to refute the arguments against value, but at some point, arguing with myself back and forth on this issue becomes ridiculous. So instead, I wanted to bring in someone who knows much more than me on the topic.

Tobias Carlisle is the author of three excellent books on value investing, including the recently released The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market, Deep Value, and Quantitative Value. He is also the founder of Acquirer’s Funds, which released its first ETF, the Acquirers Fund (ZIG), this year.

So I can’t think of anyone better to hopefully help restore my faith in value.

Here is part I of our two-part discussion on value investing. In this part we discuss the arguments against value and why the future may look better than the past decade has. In Part II, we will take a more detailed look at the process of building a value portfolio.

Just a note before we begin. This interview was transcribed from a phone conversation so please forgive any grammatical errors.

Jack: Thank you for taking the time to talk to us.

One of the more popular arguments against value that I referenced in the article is that too many people are doing it. It seems like there are more value funds than value stocks these days and they seem to have value investing covered from every possible angle. If this is true and more investors are following value, it could have the potential to reduce or eliminate the value premium over time. What do you think of this argument that too many people following value could lead to it not working going forward?

Toby: I think it’s a really good question and I think it’s a good line of inquiry, but when I look at the flow data for one thing, it’s hard to find that data and it’s hard for me to interpret what that data actually says. So I’ve asked a few different people how they look at it and I think Morningstar has some good data on the flows to various different types of funds. Defined the way Morningstar does it, the definition of value might vary from the way that we might define value. But it looks like through the first 10 years of the 2000’s the flows to value were less than the flows to growth. So there was a flow away from value to growth and then somewhere around 2009 or 10 that flipped and the flows have been largely to large value pretty consistently and away from large growth, which I was surprised to see and I would have said that it was the other way.

And the only explanation that I can have, and I spoke to somebody else about this, is that the flows, the way that Morningstar categorizes the flows is that they are to blended fund funds rather than flows to value. And that’s why it appears in the data the way it does, but we haven’t really seen any performance out of value. So they’re not actually flowing into real value. Funds are flowing to some blend. That’s an imperfect answer.

Jack: And the other thing too, you would think if there was significant money pouring into value, you would see spreads narrowing, right? It would lead to value getting more expensive relative to growth and we seem to be seeing the opposite of that. We seem to be seeing spreads getting wider so that would indicate that if the flow data is indicating a move toward value, there’s probably something wrong with it because you would expect flows to value to make it more expensive and narrow the spreads. 

Toby: So that is an interesting point too. Again, the data on this is really mixed. There was an article going around last week, I think it was a JP Morgan article, which showed the median value stock against the median growth stock, and the spread between the two has blown out as wide as it was in 2000. And that caused quite a bit of controversy among a lot of different people on Twitter in particular. And I’ve seen responses from some folks who look at median EV/EBIT, and they say that if you look at it that way value is in about the cheapest third of all periods going back to 1992 and the market is the most expensive it has been since 1992. So that’s sort of says that the spread, to the extent it’s being driven by anything, is being driven by overvaluation in the glamour deciles rather than undervaluation in value.  And I think that value is probably about 50% rich to its long run mean. So I think if you’re looking for an example, if you’re looking for corollaries, different time periods that are analogous to the one that we’re talking about now, the early 2000’s spread was very, very wide and value was very, very cheap. In 2007 the spread was very, very tight and both were expensive, which is why the drawdown in value was so great in 2007 to 2009 and value in 2000 tended to go up while the market was falling over. So now you could have a scenario where the spread is very wide but probably not as wide as it was in 2000, but value is rich. So what I expect will happen is value will not perform as well as it did in 2000. I think it’s more likely to decline, but I think that glamour and the market will come down an enormous amount, and so I think that you really do need to be long short to capture that compression in the spread because I think value will outperform glamour and the market, but I think it will still be down over the period. That’s my 2 cents anyway.

Jack: I think that makes a lot of sense. That was actually one of the questions I was going to ask because depending on how you look at the relative valuation of value, you can get very different conclusions. You can use different metrics to measure value. You can use large-cap or more total market universes. And you can use means or medians. The MarketWatch article drew the conclusion that value is historically cheap, but as you referenced Alpha Architect did their own study and found that using EV/EBIT, the valuation is more middle of the road. It seems like depending on how you look at it, you can draw wildly different conclusions.

Toby: The one thing I would say about the EV/EBIT data is that it doesn’t include financials and I think that financials are the cheapest sector at the moment. Their EV/EBIT decile is in the cheapest third of all instances. So that’s not groundbreaking. It’s still pretty good though. I mean I’d rather have value be in the cheapest third going back to 1992 that have it much richer than that. So that does indicate that it’s probably undervalued relative to its long run average.

Jack: So overall when you look at all the metrics and ways to measure it, you would say that value is cheap relative to growth compared to its history?

Toby: That’s exactly right.

Jack:  One of the simpler arguments for why value hasn’t worked is a simple argument based on interest rates. Value stocks have more of their value in the present than growth stocks, whether it be in their assets or their current earnings. Growth stocks have much more of their value in the future. So when rates are low, a simple discount rate based analysis should favor growth over value. And we have had such a long period of low rates that it could explain much of what has gone on with value in the past decade. Do you think that we are going to need rates to go up for value to turn around or do you think that doesn’t necessarily need to happen? 

Toby: No, I agree with that analysis. You know, it’s funny, I don’t actually think that anybody in the market actually does this, but I do think that if you think about it objectively, this must be the way that it goes. Very low interest rates mean that cash flows that are out further become more valuable, and we’re describing a growth stock in that scenario being more valuable. And when interest rates are higher, near-term cash flows become much more valuable and that’s a value stock. So when interest rates are low, you would expect to see growth outperforming value.

And I’ve also seen some research that shows that when inflation expectations are higher, value stocks do better and growth stocks do worse, and when inflation expectations are lower, growth does better than value. And that would seem to correlate with the interest rates as well. And so we’ve had this period of very low interest rates and low expectations for inflation. And that has meant that growth has outperformed value very materially. But I think it’s likely that this trends back to a long run mean and then probably through the other side and I think value does better in that scenario.

Jack: Yeah, it seems like that that might be a catalyst that could get value going at some point if we can ever get that to happen, if inflation expectations ever rise or rates ever rise.

Toby: It looked like we were going that direction recently because the 10 year got to 3% but then it smashed back down to 2% now. And I think we’ve seen even this year that value did very well until about February and then it’s been pretty miserable. Since February I think is basically given back all of it.

Jack: I also wanted to ask you about big data. If there is data available outside of the traditional fundamentals that value investors rely on, it could make standard fundamental data less valuable. In the article I used Walmart as a hypothetical example. If my value strategy likes Walmart based on standard metrics, but hedge funds have things like credit card data and satellite photos that show that less people have been shopping there, my standard value metrics may mislead me into thinking the stock is cheap when it is really a value trap. How do you look at the impact of big data on value investing? Do you think it could hurt returns of standard value strategies and require value investors to incorporate more data into their processes?

Toby: I think that it’s a good question. Again, I don’t really have a really great answer for it cause it’s a very big question, but my view of value is that the reason it outperforms is because the companies that we’re buying are viewed by the market as having, they are typically in a down cycle through their business cycle. And I think the market extrapolates that down cycle too far. What business and market prices tend to do is to mean revert rather than to continue in one direction. So I think that the utility of those big data and analyses that take information that aren’t captured in historical financial statements may be that they catch the turns better than analysis of historical financial statements. But I think that’s already what value does.

So if we’re looking at Walmart to use the example you’re giving as a value stock, we’re already seeing that the market has decided that Walmart’s not doing as well as the financial statements suggest just because we’ve identified the big discount. And so then if they have additional data that demonstrates that the market price is correct in that assessment then they don’t really have an edge. They just agree with what the market price is already telling them. What we’re doing is we’re taking the view that the situation that we’re seeing currently is not going to continue on in this direction and it’s more likely to mean revert. And so I think because there’s such a big behavioral component of value that you’re accepting near-term pain for long-term outperformance. And I just think that that’s still an unusual behavior in the market. And I think that for that reason it continues to outperform.

The only position that you’re taking when you’re taking a value bet is that there’s something that is not visible in the data that is going to occur in the future. And I think that’s mean reversion in the opposite direction to where that the fundamentals might’ve been trading. You’re taking that bet where if you’re wrong, that’s already priced into the stock. But if you’re right, then that’s not priced in and you should get a big outperformance to do that. And that’s the asymmetric bet that we’re all seeking with value.

Jack: The final argument against value I talked about in the article is that it is in some ways a bet against technology. When you have a sector like Technology that is experiencing rapid growth, you will almost always see it underweighted by value strategies. If that sector eventually comes back to earth, that can be a good thing, but if technology will drive growth for years to come and these firms can continue to grow their businesses like they have, having below average exposure to them could weigh down value strategies for a long time. Even if value strategies do weight technology at a market level, they end up owning the Micron Technologies and Seagates of the world instead of Amazon and Netflix, so they are not participating in the fastest growing names. What are your thoughts on value’s tendency to underweight technology and how it will impact returns in the future?

Toby: I don’t think that value investing is actually a bet against technology. I think that value is a bet against the expectations of technology. And I think that what tends to happen is in the near-term people get too excited about the impact of new technologies and they overestimate those impacts and they extrapolate early growth and add in their own very rosy projections. And that’s why the stock price seems to get so far ahead of the fundamentals. As a value investor, you want the opposite, You want really poor expectations for something. And that’s what we’re doing when we take these bets, we’re saying the expectations for these value stocks, they’re underestimating what the reality is.

And we don’t necessarily need the reality to be great. We just need the reality to be better than the way that the market’s pricing it. So I think that all of the things that we’re seeing are not in fact a complete change to the way that the economy is run. It’s just the normal boom period where investor expectations exceed the underlying economic reality for both value stocks and glamour stocks. And I think we’re going to go through a period of pain as the market corrects and then I think there’s going to be a very good period for value again when people learn that expectations should be constrained by fundamentals.

Jack: In part II of our interview next week, we will discuss the nuts and bolts of building value portfolios, including sector constraints, using value composites vs. individual metrics, and the future of the Price/Book ratio. Stay tuned for Part II of the interview next week.

Photo: Copyright: / alphaspirit

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.