John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
In March, 2009, fears of global economic collapse were rampant. The stock market was finishing up its worst decade in over 100 years, and magazines heralded the "Death of Equities." But quantitative investing strategy guru James O'Shaughnessy was saying that a "generational" buying opportunity existed.
He was right. From March 9, 2009, through Feb. 18 of this year, the S&P 500 gained 183 per cent, a stellar compound annual growth rate of more than 16 per cent.
What did Mr. O'Shaughnessy see that so many investors missed? He realized that reversion to the mean is a powerful force in the stock market. "After stocks have had an unusually great 10 or 20 years, they typically turn in subpar results over the next 10 or 20, and after bad 10- to 20-year stretches, the next 10 to 20 tend to be above average," he wrote in the updated 2012 version of his classic What Works on Wall Street. "This makes sense economically. After a great 10- or 20-year run, stocks are characterized by high P/E ratios and low dividend yields whereas after horrible 10- or 20-year returns, the reverse is true." And low valuations and high dividends set the stage for strong returns.
Right now, I think a similar mean reversion cycle is again presenting a big opportunity for investors. Value stocks – those whose prices are low compared to their earnings, sales, book value, or other business measures – have lagged pricier growth stocks since 2006. So while value stocks have significantly outperformed pricier stocks over the long term, right now, all investors see in them is danger.
But, just as fear and pessimism about stocks in general created numerous bargains in 2009, pessimism about value stocks is today creating an array of opportunities. Since 1998, the S&P value index's earnings yield has on average been 1.4 percentage points higher than the S&P growth index's earnings yield, according to Bloomberg. (Earnings yield, a measure of how cheap or expensive the index is – the higher, the cheaper – was calculated by dividing five-year average earnings of each index's constituent companies by price of the index.) Today, the gap stands at 2.1 per cent, meaning value stocks are offering more, well, value than usual.
That's good news, because over the past couple decades, the earnings yield gap has been a pretty good indicator of how growth and value stocks perform in subsequent years. Back in 1999, amid the growth-focused tech-stock boom, the S&P value index's earnings yield grew to a full three percentage points greater than that of the S&P growth index; value then went on a huge run, returning 8.5 percentage points per year more than growth stocks over the next seven years, according to Bloomberg's Nir Kaissar. By 2006, value stocks' earnings yield advantage had shrunk to about 0.4 percentage points, well below the two-decade average; growth stocks have led the way ever since. Now, value stocks have again opened up a bigger valuation advantage, making them poised to outperform.
Perhaps the tide already has turned. Through Feb. 18, U.S. value stocks were outperforming U.S. growth stocks by more than 6 percentage points in 2016.
Of course, it's possible that, in the short term, the earnings yield gap between value and growth stocks could grow even greater. But from a long-term perspective, I believe it's a good time to be buying value stocks. Here are a few U.S. value picks that get high marks from my Guru Strategies, which are based on the approaches of Mr. O'Shaughnessy and other highly successful investors.
Merck & Co.: This health-care giant ($165-billion U.S. market capitalization) operates in more than 140 countries. It's a favourite of my O'Shaughnessy-based value model, which targets large firms with strong cash flows and high dividend yields. Merck is certainly big enough, and its $2.97 in cash flow per share (versus the market mean of $1.67) and 3.7 per cent dividend yield also impress this model.
Innospec: Colorado-based Innospec ($1-billion market capitalization) makes fuel additives, oil field chemicals, personal care and fragrance ingredients and other specialty chemicals. My Benjamin Graham-inspired model likes the stock. Graham was known as the "father of value investing," and this model likes that Innospec trades for just 11.4 times three-year average earnings. It also likes the firm's strong balance sheet: Innospec has about $250-million in net current assets versus just $135-million long-term debt.
Michael Kors Holdings: This clothing designer ($10-billion market capitalization) was hit hard last spring after it announced some disappointing sales results. But it has been bouncing back strong, and the model I base on the writings of star fund manager Joel Greenblatt thinks it is still offering value. Mr. Greenblatt's approach is a remarkably simple one that looks at just two variables: earnings yield (which he calculates by dividing earnings before interest and taxes by enterprise value) and return on capital. My Greenblatt-inspired model likes Kors' 13.9-per-cent earnings yield and 59-per cent-return on capital.