Downsides to Value Investing

by JT McGee

Value investing is the least sexy investment style.

  • You won’t own the “cool” stocks
  • You won’t own the stocks that double overnight
  • You won’t own an IPO (but you might own a spinoff)
  • Your cocktail party stories will involve share class arbitrage (What? Yeah.)
  • Your home is in Omaha, not Manhattan.

Value investors are the geeks of the street. The losers who buy the stuff no one else wants to own.

Value investing is “like looking for the ugliest spouse because she will love you the most,” according to William Browne.

My biggest beef with value

I’m a value investor through and through. Frankly, anything at 18x earnings (which happens to be the multiple of the S&P 500 index) seems ridiculously expensive. You mean to tell me I have to pay for 18 years of earnings to own a company? No. I don’t do that.

Even 10X is too much for me. Really, though, when I think about it, 10X in perpetuity, assuming it is constant, is still 10% per year.

As I move deeper and deeper into the public markets I find ridiculous bargains. Companies trading at P/E multiples of 4, sometimes even less. Some trade at PE multiples less cash that are negative. No, not because the earnings are negative, but because the numerator, the PRICE, is essentially negative. (I think this is about as cheap as I’ll ever find. I’ve almost completed my second full lap of every Pink Sheet annual report.)

When you’re exposed to these ridiculous bargains, you start to wonder why in the hell you’d ever pay 15X earnings for a company. Fifteen is three times more expensive than five, all else being equal.

And then that thinking affects your view on everything. Ford, that hot stock I loved, started to “get pricey” in my mind at $15 per share, even though the market now says its worth more than $17. I was buying options when it was under $11, thinking it was worth at least $20. I got everything right – the truck rebound with housing, the remarkable market share growth with the Ford Escape, the incredible shift toward MPG and not price tag. (This year, the average new car is selling for more than $30,000. Show people a car with MPGs above 30 and they’ll justify high margin trims.) But I couldn’t hold the options. I dumped them before the money went from pocket change (market performance) to real money (150%+!).

But I’m a wuss. I hate losses more than anything. My idea of expensive is much, much lower than the market’s.

Errors of omission

Value investing is all about making errors of omission, not errors of commission. It’s better to miss out on a stock that goes up 100% than lose your shirt on a stock that drops 50%.

There’s a legendary value investor who knows my feelings right now. Warren Buffett once dumped GEICO for Western Insurance, a company trading at 1x earnings. Paying 1X earnings for an insurance company is certainly better than paying 10X earnings for another, right?

Well, not exactly. 1X is better. But GEICO grew like you wouldn’t believe, and had he simply stayed in place, he would have earned exceptional returns either way. A pricey stock can stay pricey for a very, very long time.

You know, I’ll never feel bad selling something at 10X earnings if I can buy something at 5X earnings. It’s an obvious switch. But Mr. Market delivers very powerful backhands when the 10X firm gets a multiple expansion to 15X earnings. You feel like a fool, even though 5X will give you much better long-term returns than 10X, with or without a multiple expansion. (I’m assuming that the 5X firm has reasonable capital allocation – pay a dividend or repurchase shares.)

Now I’m just ranting. My point is that even if you make the best moves in the world, timing can give you a quick and fast reality check. In the long term, the markets are a weighing machine, in the short term, they’re devised to make you feel like a fool.

The key is to remember that you buy a company because it will make you money, not because a Greater Fool is willing to pay more than you.

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