Value Investing and the Philosopher’s Stone

When J.K. Rowling finished her first manuscript of Harry Potter and the Philosopher’s Stone in 1995, she submitted it to 12 publishers, who all rejected the book. In time, those publishers would regret missing the chance to back an unknown author who would later take the world by storm. Like the publishers who passed over Harry Potter, we believe that many investors today risk missing a historic opportunity to invest against the grain in attractively valued stocks across the globe.

In recent years, many investors around the world have shunned value equity strategies, which focus on undervalued stocks that face controversy yet have promising long-term prospects. Since the financial crisis in 2008, as investors fled to safety and away from the riskiest stocks, the most attractively valued quintile of global stocks has slumped, underperforming the most expensive quintile of stocks by 5.6% a year. In contrast, over the last four decades, the cheapest stocks have outperformed the most expensive stocks by about 5.8% a year (Display). Against this backdrop, it’s understandable why value has fallen out of favor.

Yet the crisis also created huge distortions on equity markets that we think will ultimately support a recovery of value stocks. Over the last four years, massive amounts of cash have flowed out of equity mutual funds and into fixed income funds. Passive equities have become increasingly popular. And investors flocked to equity strategies focused on stocks with higher dividend yields while abandoning large-cap value equities, which are considered among the riskier types of stock investments.

As a result of all of these trends, the opportunity in deep value stocks has become very compelling. We measure this by looking at spreads between the most attractive quintile of global equities based on price/book valuations and the most expensive stocks have widened. Even after the equity market rally of recent months, these spreads are wider than almost any time in the last 50 years, except for during the technology bubble. Typically, when this ratio has narrowed and the line has declined, the cheapest stocks have outperformed strongly.

These spreads are also wide across sectors. This means that you don’t have to take concentrated positions in specific areas in order to capture the opportunity. What’s more, the quality of the cheapest stocks is unusually good. For example, the cheapest quintile of stocks has lower debt and stronger free-cash-flow yields than usual. So the inherent risks of investing in deep value stocks are lower than usual.

By the end of 2012, value stocks had slumped for five years—interrupted by a brief recovery in 2009—much longer than a typical downcycle. In contrast, periods of value outperformance tend to run for four consecutive years. So history suggests that there’s plenty to look forward to when a recovery materializes.

The legendary philosopher’s stone upon which the Harry Potter book was based was a substance that was said to be capable of turning base metals into gold or silver. While no investor possesses the powers of alchemy, diamonds in the rough can be identified in stock markets to generate premium long-term returns.

It’s very easy to be paralyzed by hindsight when the wounds of the recent crisis are still raw. Yet it doesn’t require a fantastic imagination to look forward and conceive of a scenario in which behavioral investing principles reassert themselves on global markets. For value investing to thrive, all you really need to anticipate is that cash flows and profitability will ultimately determine stock valuations again—and that’s a belief that doesn’t require any magic at all.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Kevin F. Simms

Chief Investment Officer—Global/International Value Equities
Kevin F. Simms, an AB Partner, was appointed Chief Investment Officer of Global and International Value Equities and chairman of the Global Investment Policy Group in July 2014. He has held the position of Chief Investment Officer of International Value Equities since 2012, after having served as co-CIO since 2003. He was also the Global Director of Value Research from 2000 to 2012. During his tenure as chief investment officer and research director, Simms has been instrumental in implementing significant enhancements to the firm’s cross-border research process. From 1998 to 2000, he served as director of research for Emerging Markets Value Equities. Simms joined the firm in 1992 as a research analyst, and his industry coverage over the next six years included financial services, telecom and utilities. Prior to that, he was a certified public accountant with Price Waterhouse. Simms earned a BSBA from Georgetown University and an MBA from Harvard Business School. Location: New York

Joseph Gerard Paul

Chief Investment Officer—Strategic Equities and US Value Equities
Joseph Gerard Paul serves as Chief Investment Officer for Strategic Equities, appointed in 2014, and US Value Equities, appointed in 2009. He has also served as CIO of the Advanced Value Fund since 1999. Paul was previously CIO of Small & Mid-Cap Value (2002–2008) and co-CIO of Real Estate Investments (2004–2008). Additionally, he was the director of research for the Advanced Value Fund for two years. In that role, Paul was instrumental in the genesis of the Advanced Value leveraged hedge fund. He joined Bernstein in 1987 as a research analyst covering the automotive industry, and was named to the Institutional Investor All-America Research Team every year from 1991 through 1996. Before joining the firm, Paul worked at General Motors in marketing and product planning. He holds a BS from the University of Arizona and an MS from the Massachusetts Institute of Technology’s Sloan School of Management. Location: New York

Related Posts