Over the long-term, the best performing stock strategy has been owning the cheapest companies from a valuation perspective. Enterprise/value/EBIT, divides the (market cap+debt-cash by pretax operating income.) An EV/EBIT of 5, means that if you buy a business for $1 million dollars, you are generating a 20% pretax return, or $200K. That sounds pretty good right, so it shouldn’t be too surprising that following such a strategy does well over time. However, that doesn’t mean it happens every year, or every month, but by being patient and disciplined, we get the benefit of buying such undervalued companies.
As you can see from the table in the image above which was posted by @valuestockgeek on Twitter, the cheapest stocks have dramatically under-performed the overall market in 2020. The primary reason for this is that many of these companies are related to the real economy, which was literally shut down globally causing unparalleled distortions. The massive tech-oriented companies that have been less impacted by the lock-down have outperformed dramatically, and have gotten so big that they comprise a very large portion of the underlying indices, driving returns.
1999 was a year with a lot of similar elements in that many market participants thought value investing was dead. Day trading was at its height as well, as everyone thought it was so easy to make money investing in tech. You can see the value stocks under-performed by nearly 18%. Then the Tech Bubble burst, leading to massive losses on indexes and even more on the expensive glamour stocks of the era. Over the next 7 years, value stocks outperformed by nearly 170% cumulatively. Absolute performance was up 186.85% if you add up each year for the value stocks, but this doesn’t factor compounding, which of course is one of the most important aspects of investing! $1 million dollars invested in 2000, was now worth just under $5 million at the end of 2006. This wasn’t about picking one stock, but it was simply sticking with the right strategy when it feels hardest to do so. I think this is the most appropriate comparison, because 2000 was the only time in history when the spread between growth and value was as high as it is currently.
You can also see that these value stocks went into 2020 with 3 really bad years relative to the index, which thankfully we avoided for the most part, but instead of mean reversion in 2020, we saw the gap blowout dramatically further due to these black swan events. As lock-down becomes a bad memory and life normalized over the next few years, we should see powerful mean reversion, which has the potential to generate massive returns due to the great positions we own at extremely attractive prices. We just have to be disciplined and not chase short-term performance, which historically has devastating consequences.
Let’s take a look at one of the market’s darlings, Apple (AAPL). The stock trades around $385 per share. It has a price to earnings ratio of 30.3x and earned about $12.73 per share over the last 12 months. If you inverse this, the earnings yield is 3.3% and the dividend yield is 0.85%. That means if you owned 100% of the company, it would pay you cash of 0.85% and if they paid out all earnings as dividends, the yield would be only 3.3%. It would be an aggressive assumption for them to double their earnings per share by 2025 to around $24 in EPS. If the P/E multiple stays the same as it is now, the stock could double, which would be a valuation around $3.5 trillion. However, the historical valuation has been about half of what it is now. This means that even if earnings double, mean reversion to a normal P/E for Apple of around 16, gives the stock a return of zero over 5 years, except the paltry dividend. If earnings don’t double, which is very possible and the P/E drops, you could see the stock as a big loser. The math on other glamour stocks such as Tesla, Microsoft, Amazon, and Netflix is far more concerning.
Lastly, we are in the early stages of earnings season and we have seen most of the big banks report their trough quarter, which occurred during the steepest economic decline since the Great Depression. All except Wells Fargo were profitable as we expected, despite adding massive loan loss reserves. Barring a massive lock-down or a total withdrawal of government stimulus to ease the economy back, I think it is extremely likely profits and book value metrics should grow robustly from current levels moving forward. Below are research reports for ALLY, Citigroup, and Wells Fargo, respectively. We have the horses to get us where we want to go. It is just about patience and emotional discipline at this point.