High-Potential Investments Don't Require High Price Tags
Point of View With Value Investor Bart Geer
- Investors seeking value today should be looking at stocks over bonds.
- The value style of investing has treated investors well over the long term.
- Companies with the ability to withstand event risk should fare well no matter the macro backdrop.
As the US economic recovery slogs along, value remains an important priority for Americans. The US consumer is saving more and clearly does not want to overpay for goods and services. Likewise, investors should not have to overpay to build a fruitful investment portfolio. And Bart Geer, portfolio manager of the BlackRock Basic Value Fund and long-time value investor, believes they do not have to. Mr. Geer offers his perspective on value investing in the current environment.
- Investors seeking value should be looking at stocks over bonds, as the latter are clearly rich in the current environment.
- Among stocks, the value style of investing has treated investors well over the long term on the basis of both absolute and risk-adjusted returns.
- We believe companies with high cash generation, high cash returns to shareholders and the ability to withstand event risk should continue to fare well no matter the macroeconomic scenario.
How do you see the US economy and US stocks today?
We're in a new world of investing, one in which the market is in a pretty broad trading range with a slight up-tilt. This trading range will likely persist for a multiple-year period as deleveraging continues around the world. l think growth will be tepid versus what most of us know of past economic recoveries, and I believe we will continue to see event risks crop up periodically. Against this backdrop, I think equities are pretty attractively valued and offer excellent inflation protection over the long term. They also offer very good cash yields, much better than government fixed income, and competitive with, if not better than, spread product (corporate bonds and other non-government fixed income).
Why is this a good time to be a value investor?
"I've been a value investor for more than 30 years. I think it's the only way to invest."
I've been a value investor for more than 30 years, so I'm clearly biased. I think value is the only way to invest. Over the long term, value has treated investors well on both an absolute return basis and on a relative risk-adjusted return basis. (See graph below.)
Past performance is no guarantee of future results. The information provided is for illustrative purposes and is not meant to represent the performance of any particular investment. Assumes reinvestment of all distributions. Large Cap Value is represented by the Russell 1000 Value Index; Large Cap Core is represented by the S&P 500 Index; Large Cap Growth is represented by the Russell 1000 Growth Index. The indices are unmanaged. It is not possible to invest directly in an index.
The value universe is actually quite broad, extending from deep value, to everyday value to GARP (growth at a reasonable price). If you're willing to accept that definition, we believe it's always a good time to be a value investor. So when the economy is slow and the inclination is to lean toward growth, that means we favor GARP over deep value. GARP companies are those that flirt in and out of the growth universe; sometimes they come down in our universe and, we would argue, sometimes they are in both.
Growth investors define their universe by how fast companies are growing, usually based on earnings, sometimes based on sales. We define our universe by how cheap companies are. It's possible that you can actually be growing and cheap, in which case you're legitimately in both worlds. Many people don't acknowledge that stocks can be both, but there's a reasonable amount of overlap. In a relatively inexpensive market, such as we have today, there's actually a fair amount of overlap.
You say it's a relatively inexpensive market. Stocks aren't overvalued after the run they've had since the 2009 low?
Stocks are actually inexpensive on a few measures. If you look at prices relative to reported earnings and cash flow, stocks are inexpensive. If you look at stocks relative to interest rates on bonds, again they are inexpensive.
But the picture is not completely clear. Looking behind these top-line numbers, the critical issue is the fact that companies are at very high profit margins versus history. Based on fourth quarter 2012 results published to date, cash flow margins appear to be maintaining their high levels. As long as that persists—i.e., as long as we can either maintain or increase profit margins—we're in good shape. If something were to come along and impact profit margins, then debatably, stocks might not be cheap. We don't necessarily see anything on the immediate horizon, but we are watching government regulation and tax rates carefully, because these are the types of things that can impact profit margins.
So, the short answer is we see stocks as cheap, but with some pretty important caveats and with realistic expectations for continued volatility along the way. Looking out, I think equities are going to be a good asset class for people who hold them over the long term. They offer much better inflation protection than bonds—both spread product and government product today. As illustrated in the table above, the returns for the majority of fixed income assets are unappealing even after moderate inflation, and only look worse after factoring in the impact of taxes.
Yields Unappealing After Inflation
After-Inflation Returns for Traditional Fixed Income Securities
|12-Month Yield||After Inflation*|
|Taxable Money Markets||0.03%||-1.67%|
|10-Year US Treasury Bond||1.78%||0.08%|
|Short-Term Bond Funds||1.89%||0.19%|
|Government Bond Funds||2.45%||0.75%|
|30-Year US Treasury Bond||2.95%||1.25%|
*Based on trailing one-year All Urban Consumer Price Index change of +1.7% as of 11/30/12.
Sources: US Treasury, BLS, Bankrate.com and Morningstar, Inc. as of 12/31/12. Past performance is no guarantee of future results. Taxable money markets reflect the Morningstar Taxable Money Market Funds category average, short-term bond funds the Morningstar Short-Term Bond Funds category average and government bond funds the Morningstar Intermediate Government Bond Funds category average.
So stocks look good relative to bonds, but the fund flows show investors shunning stocks.
It comes down to a battle between short term and long term. In the long run, there are not many people who dispute that bonds look richly valued and stocks look pretty inexpensive. The issue, and the reason why the flows seem to be going into bonds and coming out of active equities, is that most people are focused on the present. You have this ironic situation in which people are pretty sure that, for the long term, their money is going to the wrong place. But they also seem pretty convinced that, in the short term, their assets are going to the place where they're going to get performance.
I can think of only one other time in my career when this type of scenario persisted and was of the magnitude that I see today. It was during the New Economy of the late 1990s, when a lot of people acknowledged that New-Economy stocks were on the rich side. Those who didn't acknowledge it, completely drank the Kool-Aid and felt the dot.com stocks were going to grow into their valuations. While almost all of them did not grow into their valuations, the prevailing sentiment seemed to be "they're working now," and as long as they were working, investors chose to be there rather than in value stocks. Ultimately, value stocks had a phenomenal multi-year run after that time period as the dot.coms crashed. The bar chart on the following page shows that the investor risk aversion today is actually greater than the greed of the tech bubble. This bit of history illustrates that when people flock to an asset class for a short-term reason, knowing full well they shouldn't be there long term, the environment is setting up for a huge pendulum swing. So, I like equities over fixed product for the long term, but I acknowledge that equitieshave had a lot of volatility lately and that has a lot of people scared and withholding their money right now. That said, equity returns over the last four years have been very solid.
What is your approach to value investing?
I am a 30-year value investor and I try to run large-cap value money in a diversified, risk-controlled way. My comfort zone in value ranges from deep value through GARP, and as I mentioned before, I believe you use those appropriately at different times through the cycle.
I believe obsolescence risk and a lack of catalysts are among the key risks that need to be managed by value investors. We manage these risks through a process that combines fundamental research and a quantitative screening and optimization process. By doing this, we have been able to achieve diversified sources of excess return.
I believe portfolios built on companies that have high cash generation and high cash returns to shareholders are going to continue to fare well. I think it's important to look for shock resistance in a stock—the ability to withstand event risks. I try to build all-weather portfolios and pick stocks that can do well under multiple macroeconomic scenarios.
What do you mean by obsolescence risk and catalysts?
We see these as two of the biggest risks facing value investors, for obvious reasons. Consider this example: At one time, buggy whips were probably a growth business. Everyone had to have one—how could you drive your carriage without a good buggy whip? Undoubtedly there were those who thought investing in buggy whips was the safest thing to do, because people were always going to need them. Then along came the internal combustion engine and the entire model was reinvented. Knowing markets, I have no doubt that somewhere along the way, buggy whip companies would have sold extremely cheaply to their current cash flow. So someone taking a static look at the valuation would have said, "These are really inexpensive stocks, we're value investors, we should buy them, how can we lose?"
The answer is you would have lost because you might have received cash flow for a few years, until it grew less and less and eventually there was nothing at all, not even a company. You also would have paid a huge opportunity cost; you might not have made any money at all.
The point is that every industry that is in a downward spiral will come through the value universe because it will look inexpensive. Some people think value investors simply buy the cheapest stocks. Clearly that's not a good strategy,because if it's cheap, getting cheaper, going to zero, it's not going to be a good place to deploy long-term capital. So, as value investors, we have to acknowledge that. Many so-called "value" investors do not. Over my career, I have less and lesstolerance for obsolescence risk because, once a company is in that category, it's very difficult to recover and become a reasonable investment. It's a pretty dangerous category.
Also dangerous is buying value for value's sake. We call it "dead money" risk. In other words, it's going into a situation that's cheap on some of the metrics we hold dear—e.g., price to cash flow—but without a clear idea about why that company stock might appreciate. We want to identify situations where things are inexpensive, but have catalysts for growth.
Tell us more about your investment process.
We screen roughly 750 to 800 names for inclusion in our portfolio. We don't require specific valuation thresholds; we think all value names are game. We use a fairly rigorous quantitative ranking model to help us prioritize the universeand decide where to do fundamental work. We combine that quantitative screen with fundamental research to arrive at a portfolio of roughly 100-135 names. Notably, the quantitative screen cannot put stocks into the portfolio. Every stock needs to be vetted by the fundamental side of our process.
We're looking for stocks that are deemed to be misvalued. We look for stocks that have the ability to withstand multiple economic outcomes. We don't build a portfolio of stocks that thrives in one expected economic outcome, but is suboptimal in others. We try to build a portfolio that is relatively all-weather. That may mean we lag in very strong up markets, but we have found that we more than get it back in the flat or less aggressive up markets, and certainly in the down markets.
What traits do you like to see in a stock?
There's really no easy answer, simply because we're not looking for the same thing in every company. There's no checklist for good or bad. We strive to understand each business and relative positioning to assess what's important in a given situation. We think one-size-fits-all is a too simplistic view of the world. We try to dig in and find out what the critical issues are, analyze those issues, and analyze valuations relative to the execution of the critical issues and opportunities we're looking at.
Only from there can you begin to determine whether it's an investment opportunity or not. Valuation is important, but only relative to your understanding of the strengths and weaknesses of the company you're buying. You should expect to pay more for a strong company, and you should be content to pay more for a strong company.
Where are you finding value today?
We expend most of our risk, and historically have gotten most of our return, from stock and industry selection as opposed to macro factor selection, such as market capitalization or sector selection. While we don't get a lot of our performance from this, I can say that large caps look pretty attractive and we're modestly tilted toward large caps right now. That said, if we found a great small- or mid-cap name in our universe, we would certainly buy it. In fact, we like the diversification of having both.
Aside from large caps, we also see value in stocks with a history of growing dividends, as opposed to those that are paying the highest current dividend. It's the growth we like rather than the static level of the dividend.
We do a lot of mapping of one company versus another, and industry versus industry. From a sector perspective, we see value in healthcare and some parts of consumer cyclicals. Likewise, there's value in some parts of technology, especially the large caps. We also see growing value in the financial area, although you need to keep your eyes open there.
Any words of advice for investors, particularly those who may be shunning stocks?
I would remind people that markets climb a wall of worry. Equity returns over the past three years, while they haven't felt great, are actually quite respectable. Back to my earlier point, there doesn't seem to be a lot of dispute that there's long-term value in equities, and yet that's not where money is going. I think investors should ponder on that, because the last time this occurred, the right thing to do was to go into the cheap long-term asset class. Not getting that trade right was a very big deal then, and it could be setting up for a similar scenario now. Investors should also consider removing some of the anxiety placed upon themselves by working with a financial professional and investing in a professionally managed fund that does the hard work of finding value for them.
Past performance is no guarantee of future results. It is not possible to invest directly in an index. Indices used are as follows: Oil: WTI Index; US Stocks: S&P 500 Index; Gold: US$/troy oz.; Bonds: Barclays Capital US Aggregate Index; International Stocks: MSCI EAFE Index; Inflation: Consumer Price Index (CPI); Homes: Median sale price of existing single-family homes. Average investor return is based on an analysis by Dalbar, Inc., which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Returns are annualized (and total return where applicable) and represent the 20-year period ending December 31, 2011, to match Dalbar's most recent analysis.
About the Author
Related by Topic: Equities, Economic Outlook
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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager profiled as of February 5, 2013, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. The BlackRock Basic Value Fund is actively managed, and its holdings and portfolio characteristics are subject to change.
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