Strategy
Steve Romick & Brian Selmo May 21, 2021
Blindly practising time-honoured value investing is a dangerous occupation, not least because of the pace at which companies are being disrupted by technology. How businesses can be assessed for their longer-term value are among the themes examined in this commentary.
This guest commentary discusses what it means to be a contrarian value investor and how it relates to today's investment landscape. The authors define contrarian value as buying something and getting more than what you paid for, either because a good business is facing a cyclical challenge or because investors do not fully recognise the quality of that business. Steve Romick and Brian Selmo, co-portfolio managers at Nedgroup Investments, explain that in either case, assets that are mispriced in this way result in a rate of return that is better than the market's. The goal of the group's Contrarian Value Strategy is to generate long-term equity-like returns, take less risk than the market and avoid permanent impairment of capital.
The editors are pleased to share these views and invite responses. The usual editorial disclaimers apply. To enter the debate, email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com
Contrarian value investing is separate from value investing
People tend to think of value investing as owning the shares of a proven business in frequently cyclical industries that do not have much growth; while considering growth stocks to be those shares of businesses that can seemingly grow at a healthy clip for years and have less economic cyclicality.
We view contrarian value investing as buying growing businesses at a price that can offer a margin of safety that protects capital if all does not go as planned. Traditionally that protection comes from a companyâs balance sheet, that is buying below book value for example, or maybe by getting some unrecognised real estate value or some other hidden asset.
Blindly practising time-honoured value investing is dangerous. Many of those types of companies have been disrupted by some of the most prolific technological innovations the world has ever seen. While some companies have adapted, others have not.
Focus on evaluating businesses
Our job is to understand what changes are likely for a business. Who will win and who will lose? It is important to avoid those losers and to avoid overpaying, even for an excellent company. A winning business does not necessarily translate to winning stock. Microsoft stock for example was lower in 2009 than it was in 1999 even though it delivered high-teens growth along the way. Price will always matter.
We expect contrarian value strategies to under-perform in markets where price does not matter. Particularly those characterised by great faith of what might be but is yet to be proven; those businesses that are not earning money today, but people expect them to be earning in 10 years. Their business models are still untested.
Contrarian value strategies should outperform in those periods where an industry group or an asset class falls from grace. We could do well by avoiding some of the weakness as prices fall and possibly by picking up inexpensive good assets in weaker market conditions.
Cyclical vs secular change
The world is always changing so it is important to separate cyclical change from secular change. We believe that much of what has happened in the last year has been cyclical.
Secularly, many businesses have benefited from the changing environment in the last year. Video stream for example was already growing quickly before the pandemic. It has taken more share from traditional media as people have been forced to find ways of entertaining themselves at home at the expense of cinemas, broadcast television and cable networks.
We are constantly forced to examine what businesses are more likely to thrive a decade from now and those that could be struggling. Note that we are speaking about the businesses and not the stock prices, which are a secondary consideration. We begin with trying to understand which companies will be good or better a decade from now.
Thinking with this mindset forces us to continually adapt to the expected changes that are going to come.
Investment challenges
One concern is that interest rates are at 1,000-year low and most people have never seen interest rates rise. Another is inflation. Given the unfettered sovereign borrowing, how might interest rates and economies respond and what kind of pricing power do companies need to have to sustain margins, generate good free cash flow and maintain a level of return on capital?
Today's start position is that valuations are not cheap and we are dependent on low rates and good earnings growth. Should one or the other change then there could be some market volatility.
Conversely, a post-pandemic economic rebound is already happening. Society has proven resilient, bad economies come and go and companies and investors have adapted and survived. Having lived through a pandemic, the global community now knows it takes a lot to get us down.
Lower rates are a concern, but these are unlikely to significantly change in the foreseeable future as governments have incentives to keep rates as low as possible. This might continue to provide support, if not even fuel for this market.
Applying contrarian value
Different businesses have different fundamental economic characteristics and ought to trade and be valued on different numbers. What is a margin of safety in one is going to look very different in another.
In digital businesses for example, you may have very low or no marginal cost of revenue or customer acquisition. What that means is that things like scale advantages, or the likelihood of reaching them are a lot more relevant than what is on the balance sheet or maybe the historic income statement. The fact that the business did not make money two years ago becomes irrelevant to their prospects five years out.
This is central to how we think about valuing these businesses five years from now. The balance sheet and income statement reflect what is known about the past â your experience as an investor is dependent on what is going to happen in the future. It is vital not to get stuck in a less relevant view of a business or its opportunity.
The current market and portfolio positioning
Spring 2021 feels better than spring 2020. Over the last three months or so we have been selling down some of the more cyclical positions, including some financials that came back strongly and are trading at very different valuations than they did six months ago or even in January 2020. We are gradually shifting into things that are more defensive in nature in terms of their underlying business profile.
We think that valuations are generally high and do not see a huge pocket of opportunity to generate out-sized returns. With that and the low starting point for yields, our expectations are modest over the next three to five years.
About the authors: Steven Romick is a founding partner of First Pacific Advisors, a Los Angeles-based institutional investment manager. He serves as portfolio manager of the FPA Contrarian Value Strategy. Prior to joining FPA, he started his own firm, Crescent Management, in 1990 in order to focus on finding out-of-favour, low-risk/high-return investments in various parts of the capital markets.
Brian Selmo is portfolio manager at First Pacific Advisors. He serves as portfolio manager and director of research for the FPA Contrarian Value Strategy. Prior to joining FPA, Selmo was founder and managing member of Eagle Lake Capital, and portfolio manager of its predecessor.
