The Key to Value Investing: Follow the Rules (Most of Them, Anyway)

Jay Hodgkins

In the above videos, speakers at the eighth annual University of Virginia Investing Conference offer insight into the current economic landscape, opportunities in a diverging global monetary setting and implications for investors.

“There are rules to value investing, and they must be followed.”

International Value Advisers Chief Investment Officer Charles de Vaulx made his proclamation at the start of the eighth annual University of Virginia Investing Conference held at the Darden School of Business 12–13 November and hosted by Darden’s Richard A. Mayo Center for Asset Management.

During the Fundamental Stock Panel, de Vaulx and his fellow panelists — Gregory McCrickard of T. Rowe Price, Billal Sikander of Monroe Hall Asset Management and moderator Don Wilkinson III (MBA ’92) of Wilkinson O’Grady & Co. — defined value investing as the age-old art of uncovering a diamond in the rough. They trade in companies that they believe are fundamentally misunderstood by the market, and as such are significantly undervalued and primed for big gains.

There’s a formula to uncovering these diamonds, the rules de Vaulx foreshadowed. Among those he and his fellow panelists listed were:

  • Buy safe and cheap.
  • Look for a strong balance sheet and cash flow growth.
  • Make sure the right management team is in place, particularly for small companies.
  • Seek the best business models.
  • High-yield bonds can be equities in disguise.

“We want quality, and we hope and pray that the quality is misunderstood [by the market],” de Vaulx said. “Those are the great companies in the [Warren] Buffett sense. Buffett’s genius was understanding that what made a company valuable isn’t just growth.”

Of course, some rules are made to be broken, and de Vaulx followed his insistence on rule-following with a tale of the rule International Value Advisers stopped following 30 years ago. He said it was conventional wisdom in value investing not to focus on macro trends and data. However, he said he recognized that only made sense in the “good old days” when debt levels were much lower. Now that debt is skyrocketing around the world, he said, “one day the party will end,” and value investors must understand macro trends to avoid taking a hit when that time comes.

Citi Investment Research Chief U.S. Equity Strategist Tobias Levkovich presented at the conference and agreed with many of the fundamental strategies the value investors brought forward.

Underpinning their strategy, he said, was the fact that investors often don’t act rationally, the way economic and market data indicate they should act.

For example, Levkovich said that right now, a preponderance of economic and historical market data suggests that the U.S. economy is on solid footing with little risk of recession, and U.S. stock markets are primed for gains. Levkovich explained that a mix of 20 sentiment factors, including data on short interest positions, margin debt, gasoline prices, trading volumes and others, indicates that market participants are in a mild state of “panic” and that history shows a high probability for an up market following a panic sentiment. The gap in perception versus reality means there are a lot of opportunities for savvy investors right now.

Levkovich pointed to the energy sector, which has been battered by low oil and other energy commodity prices in the last year. However, the reaction to the weak fundamentals has gone too far, Levkovich said, and he believes the bearish sentiment against energy stocks today and a sunnier outlook in the coming years means that now is the time to invest in energy.

On the other hand, the outlook for spending on health care is strong, but Levkovich described a recent run-up in health care stocks as the market gone “berserk.” He said Citi sees at least eight indicators that show the health care sector is overvalued and primed to fall back. Similarly, consumer discretionary stocks — retail stores — have also performed well as consumers spend the extra money in their pockets from cheap energy prices, but now appear overvalued.

Levkovich’s last bit of advice for investors fell right in line with de Vaulx: Be aware of macro trends, but also understand that most investors will do the wrong thing in response to them.

He said the top 50 stocks trading on the S&P 500 are radically different companies — like Google, Exxon and Merck — that should move independently of each other, but they often move in tight correlation down when the market is overreacting to macro news and selling off stocks wholesale. He said that is a prime opportunity to buy a stock in a fundamentally strong sector. On the flip side, Levkovich said, “when everyone thinks they’re a genius” and those top 50 stocks are trading without any correlation to each other, that’s when a macro event is primed to cause turmoil.

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