Dear fellow investors,
One month ago, I was privileged to speak at the London Value Investor Conference (LVIC). Fortunately for us, Ben Inker, co-head of asset allocation at Grantham Mayo Van Otterloo (GMO), kicked off the session with a presentation arguing that deep value stocks were historically attractive relative to all forms of growth stocks, and very compelling versus quality value stocks. Imagine how pleased we were to have strong academic/empirical evidence for the argument we made in Omaha at the University of Nebraska-Omaha’s Value Investor Conference. Our talk argued that this is a Ben Graham (hunt for deep value) moment, not a Charlie Munger (pay up for wide moat quality) moment.
Writer Lauren Foster from Barron’s brought this out into the open in a June 7, 2023, article titled, “Deep Value Stocks Are Super Cheap. Why a Recession Isn’t a Worry.” Here is the synthesis of Ben Inker’s remarks:
- A value style of investing is often associated with cyclical stocks.
- But GMO’s Ben Inker looked at the performance of value across a range of recessions from the past 50 years and found no empirical evidence that value stocks consistently underperform during recessions.
- Right now, Inker sees plenty of opportunities for investors to scoop up so-called deep value stocks—the cheapest 20% of the market.
Let me restate our reasoning to readers. First, when the Saudi Sunday cut the legs off the U.S. oil and gas industry in March 2020, commodities hit a 220-year valuation low relative to common stock valuations. Second, the monetary stimulus provided by two presidential administrations to get us through the COVID-19 shutdowns was massive ($9 trillion). Third, the slow-starting millennial population group would get their adult lives started (yes, at 30 years old) in big numbers. Putting it together, you have too many people, with too much money, chasing too few goods (the classic definition of inflation)!
Inker went on:
“The cheapest tier of stocks is trading at just about the largest discount to the market we have ever seen,” he said. “That strikes us as a very good group of stocks to own.”
Value stocks always trade at a discount to the market, but the size of the gap has a large impact on the attractiveness of the group, Inker said. The cheapest 20% of the U.S. market is now less expensive than in 98% of all of months going back to 1970. “The only times it has ever been cheaper were five months at the peak of the [tech] bubble in 2000 and three months in the fall of 2020,” he said.
Let me put this all together. The value factor has outperformed the stock market over long stretches of time because when you are wrong, these kinds of stocks go down less than growth stocks. A dollar saved is more valuable than a dollar earned in the world of compounding. Inker points out that recessions have not been more damaging to deep value stocks than the rest of the stock market. Here is his conclusion:
Based on GMO data, the cheapest 20% of the market normally trades at about a 39% discount to the market, whereas today it is trading at a 53% discount. If that “deep value” group reverted tomorrow to its average valuation discount it would outperform the market by 30%, Inker said.
On a trailing 12-month basis, our portfolio trades at 9.1x after-tax profits compared to 21.1x profits for the S&P 500 Index. This is the biggest valuation gap we can ever recall in over 15 years of the strategy’s existence! Therefore, from a theoretical standpoint, it mimics the opportunity described by Ben Inker’s research.
One week ago, everyone on our investment team was asked which of our existing holdings looked the most attractive for purchase. They submitted three names each, which overlapped with my own list of eleven stocks. It’s unusual to have so many compelling buys, but Mae West used to say, “Too much of a good thing can be wonderful.” My list was dominated by our deep value stocks like Mall/REITs Simon Properties Group (SPG) and Macerich (MAC), Apache (APA), Ovintiv (OVV), Devon Energy (DVN) in the oil patch, our bank holdings including American Express (AXP), Bank of America (BAC) and J.P. Morgan (JPM), and miscellaneous stocks like Warner Bros Discovery (WBD), Amgen (AMGN) and Qualcomm (QCOM). We like what we are doing regardless of what unfolds in the economy because we believe we have the laws of mean reversion in our favor.
If Inker’s work is correct, we have no more portfolio risk due to recession than normal. Whatever the S&P 500 Index and the U.S. economy have for us going forward, we believe our approach and Inker’s case could help investors who fear stock market failure.
The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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