The U.S. stock market hit record highs early in the year, only to fall back in March to post mostly flat returns for the quarter. Still the S & P 500 index was up nearly 1%, which would take 4 years to match in today’s bank savings accounts. International stocks, after trailing the U.S. for most of the past 6 years, finally posted a good quarter, up +2.6%. On average, value stocks underperformed growth stocks, and large stocks underperformed small stocks for the quarter. In contrast, IMS had a very strong quarter in our flagship capital value strategy, which resulted in positive recognition on page R8 in the March 9th edition of the Wall Street Journal. Our success was the result of good old-fashioned value stock picking, which will be the focus of this newsletter. Volatility in oil prices dominated the headlines in 2015, but the real action was in the 10-year Treasury, which whipsawed back and forth on Fed rumors and comments between 1.67% and 2.24%.
The U.S. stock markets are no longer at bargain prices as measured by traditional valuation tools. While the Dow Jones Industrial average may have a P/E of 15, the NASDAQ sports a P/E of 29 as technology, biotech and IPO’s have been hot. For this reason, we believe stock picking, and not just buying the entire market, makes more sense than ever. The major stock market indexes have rewarded investors handsomely since the March 2009 lows – the S&P 500 has appreciated 197%, the Dow Jones Industrial Average 165% and Nasdaq a staggering 274%. But just because the market has been strong the last 6 years, doesn’t mean it’s time to sell as there have been 5 other bull markets that lasted considerably longer. We see nothing on the horizon that would suggest this one is about to end. In fact, the title of this newsletter last quarter was “12 Reasons Stocks Should Return 10% or More in 2015”, and those reasons are all still very much intact.
We will continue to pay close attention to corporate profits, employment stats and evidence of inflation as that will give us insight into the Federal Reserve’s next moves. The energy market will be critical to our analysis as well, since it impacts consumer spending, capital expenditures, overall corporate profitability and US employment rates. Our advice to “stay the course” has been right as this bull market continues to surprise many with its stamina and resilience.
The Real Value in Value Investing
Value investors seek stocks of companies they believe are undervalued. The market often overreacts to both good and bad news, resulting in stocks that can be mispriced. Value investors essentially attempt to buy low and sell high, while growth investors buy high and attempt to sell higher. Dozens of academic research studies demonstrate that the value style out performs the growth style handily over time, mainly because it holds up better in down markets. Put simply— Value has higher returns and better defensive characteristics than Growth. Warren Buffet, Michael Price, Bill Nygren, and Sir John Templeton are classic, patient value investors, whose successful careers span multiple decades. Yet many investors find buying low a hard strategy to execute, as it involves buying when the news isn’t necessarily good. There is always a good reason why a stock is low. The key is identifying if the underlying assets are mispriced, if the present circumstances will improve and how long it will take. Sifting through the opportunities, that’s our passion.
IMS runs a strategy called “Dividend Growth”, however, it’s not a growth strategy. It’s a classic value strategy, made up of dividend-paying value stocks that have a history of annual dividend growth (increases). It’s still very much a value-oriented approach.
So what are some value stocks we like today? How about Occidental Petroleum (OXY) and InVivo Therapeutics (NVIV), two companies that are about as different as they come. True value investing is multi-faceted. Value is not just one metric such as P/E (price-to-earnings ratio) or absolute price. A company could be undervalued in terms of historical or future sales, earnings, book value or cash flow, for example. A company could be undervalued based on what a larger, strategic buyer might pay for the entire company in a merger deal, or based on the future revenues of new product that is still under development. There have been cases where we have made significant profits on companies that didn’t even have a P/E, because they had no earnings and were losing money. Yet their large subscriber base, in the case of Leap Wireless (better known as Cricket) ended up being worth a fortune to AT&T.
In the case of $63 billion, profitable oil giant Occidental Petroleum (OXY), the value case is very simple – we get paid to wait for oil prices and the stock price to eventually return to more normal levels. It’s another argument entirely, whether and when oil prices will rise again, but it’s clear that OXY will pay you nearly 4% annually in dividends while you wait, and will rise in price substantially with the value of their proven oil reserves. It is also beyond debate that the stock is at $79.62 (4/27/15) down from $117, that it is a serial dividend raiser and that it has very little debt (10% debt-to-capital ratio). We believe that lower oil production will eventually lead to higher oil prices and the underlying assets are being significantly mispriced. This is a classic value stock.
In the case of Cambridge, Massachusetts-based, InVivo Thera-peutics (NVIV), the value case is anything but classic. The company is currently in human trials with their experimental treatment designed to help the spine heal after an accident. Accident patients who elect to have this biodegradable, neuro-spinal scaffold surgically implanted around the source of the injury are hoping to avoid being paralyzed from the chest down. Typically, the balance of their life would be spent in a wheel chair and they would have no bowel or bladder control. Without getting into the specifics, the FDA recently allowed the 10-year old company to test its product on two willing patients and the results so far are very promising. Keep in mind, this is a highly speculative investment and could not be more different than OXY. NVIV is losing money, they have a heavy debt load, they are tiny (you could buy the whole company for $336 million vs $63 billion for OXY), and they pay absolutely no dividend. However, one of the possible value metrics to consider is future value of the company to a strategic buyer, like a large medical device maker (Baxter International, Boston Scientific, Medtronic). This biodegradable, neuro-spinal scaffold, if it works, could revolutionize the treatment and recovery prospects for spinal cord injuries. All the product needs to do is prove that it is safe and that it can mildly improve the prospects for recovery. If it can do that, it could own the spinal injury market, until such time that a better product comes along. No, it is not a traditional value stock, but it is currently undervalued based on what it could be worth in the future, if their product were to become the standard of care. At $12.14/share (4/27/15), down from $22, it represents a compelling value. Warning – this company is small, the stock is speculative and highly volatile. We do not recommend trying this one at home.
As value investors, we believe in rolling up our sleeves and understanding the underlying business of the stocks we own and how trends in economy and other factors will impact the company. Momentum and some growth style investors can be short term holders who rely more on the “greater fool” theory. After buying high, they bank on the momentum continuing and someone else coming along and paying an even higher price. We try to identify trends and themes that are actually playing out in society, and then find undervalued companies that stand to benefit. Some examples include healthy eating, rising energy prices, do it yourself (DIY), biotech advances and rising interest rates.
Herd Mentality vs Contrarian Discipline.
“What the wise man does in the beginning, the fool does in the end.” This old adage is critical to our investment process, Most investors buy (stocks) with enthusiasm as the cycle pushes prices higher and they hit the panic/sell button after prices have already declined. That phenomenon is human nature and defines the herd mentality. A recent example would be Apple’s stock in 2012. From late November 2011 to mid-September 2012 Apple rose 93%. The media was falling over themselves with glowing articles. Fortune Magazine’s featured Apple on the cover. The herd was on board, analysts were indicating Apple would be the world’s first trillion dollar company and 86% of the analyst community rated Apple a buy or strong buy. What proceeded to happen over the next six months caught all investors by surprise. Apple dropped -44%. There were no new investors to buy the stock and push it higher. Everyone was already in the stock. By the time Apple’s stock declined -44%, and stayed there for several months, the herd decided to stampede out of the stock. Value investors saw a wonderful business with a durable brand, trading for less than the market’s multiple, a solid balance sheet and almost 2x the markets growth potential. It seems like a no brainer now, but in late 2012 it was very unpopular to buy Apple.
So what is the real Value in Value Investing? It’s a smarter approach, it makes sense intuitively, it makes cents literally, it out performs growth and momentum strategies over long periods of time and it tends to hold up better in down markets. IMS will continue to deploy our strategies using these and other value investing maxims. Our style is not for everyone, it’s hard to do as it goes against the grain of basic human nature, but we like it that way. If it was easy and felt good, everyone would be doing it. We like the fact that individual stock picking and identifying beaten-down, undervalued stocks is becoming a rarity with the rise of ETF’s, index funds and robot investing. We will continue Building Wealth Wisely.