Will value strategies still work in a recession?
Tim Bennett Mar 13, 2009
Every successful stockmarket investor needs a system – otherwise you're really just picking stocks at random, in which case the odds of getting it right are no better than betting on the horses. Value investing is a particularly attractive system to many people in that it should allow investors to be relatively lazy. You buy a stock when it looks cheap based on fundamental analysis using various financial ratios (see below). Eventually, other investors should notice the fact that the share is available at bargain levels, and so drive the price higher. As long as you can accept that you might be waiting a while before this happens, you can just buy and hold for as long as it takes. But recent stockmarket carnage has taken its toll on stocks across the board. So is value investing worth sticking with?
Value investing: three possible outcomes
Keen value investor James Montier of Société Générale has looked at the "three possible paths" for the global economy and the implications for value investors. "Most optimistic" is the idea that central banks succeed in creating inflation through a combination of interest-rate cuts, buying up bad assets and printing money (or quantitative easing). That would set the scene for a surge in stock prices around the world. No equity investor would want to be left on the sidelines, particularly at a time such as now, when, on many traditional value measures, stocks look relatively cheap.
That's the upbeat view. The next, less-pleasant scenario, is the prospect of a Japanese-style slump for the world economy. In this case, industrial production and inflation would stay broadly flat, as has been the case in Japan for the best part of two decades. Sounds grim. But the good news, says Montier, is that, even in Japan, "value strategies have still plodded along nicely". Buying the cheapest stocks based on price/book-value ratios generated an average 3% return per year against an annual 4% loss for the market as a whole, using US$ returns for the Japanese stockmarket between 1990 and 2007.
However, scenario three – a replay of the 1930s – would render most stock-picking strategies useless. This was a time when US industrial production fell 50% peak to trough, while over a period of three years wholesale prices tumbled by 10% a year and consumer prices by 9%. A Bridgewater Associates study shows that, during that time, despite huge variations in earnings performance, "the prices of the best 20 and worst 20 earning companies fell by similar amounts, 80% for the best and 96% for the worst". As Montier puts it, this isn't "rocket science". Clearly, "in a world in which nominal GDP is halving you probably don't want to own equities".
What to do
So what should you do? Although grim, the 'Great Depression part two' scenario is by no means an outside chance – it's at least as likely as the upbeat outcome. As Nouriel Roubini tells Forbes, we are seeing a "synchronised freefall of GDP, income, consumption, industrial production employment, exports, imports, residential investment and capital expenditure". However, as Montier says, "if the Japanese experience is the right template... then value investors have little to fear". So the best idea may be to identify stocks that look cheap, but are also most likely to survive in the long run (based on a bankruptcy measure such as the Altman Z score) and drip-feed money into them.
The best value stocks to buy now
Benjamin Graham is often referred to as the father of value investing. James Montier uses one of his approaches to screen out stocks based on three criteria. The earnings yield (earnings per share as a percentage of the share price) should be at least twice the AAA bond yield; the dividend yield at least two-thirds of the AAA bond yield; and total debt less than two-thirds of tangible book value. Plus the stock should have a Graham & Dodds (G&D) p/e ratio of below 16 (the G&D p/e is based on the share price divided by ten-year moving average earnings, and gives a clearer picture of a share's valuation by ironing out fluctuations in earnings from year to year). Montier believes the stocks his screen now delivers include "some truly incredible opportunities".
Among the stocks Montier lists, we like oil majors BP (LSE:BP) and Royal Dutch Shell (LSE:RDSA), which yield 7.2% and 6.6% respectively. Other interesting-looking stocks thrown up by the screen include US technology giant Microsoft (US:MSFT), which yields 3.1%, and Swiss drugs group Novartis (Zurich:NOVN), which yields 5.0%.