Are all "Graham" stocks junk?

Have you ever walked down the street and inadvertently stepped on a piece of gum?  It's annoying.  A piece of previously enjoyed food carelessly discarded on the ground and is now stuck to your shoe.  In many ways investing in the mold of Benjamin Graham is like a sticky piece of gum on the street for most investors.  It's an idea that had merit seventy or eighty years ago, but is old fashioned and is now stuck to everyone's shoes.  Most value investors have spent a considerable amounts of time metaphorically scraping Graham's ideas from their shoes.  But amazingly there are still a few still chewing on that old gum and enjoying it, why?

The common sentiment is that Graham-esque stocks, that is stocks that trade at low valuation multiples such as a stock trading at10x earnings and 75% of book are junk and a waste of time to research.  The implicit assumption in all of this is that the market is somewhat efficient and if a business trades for a poor multiple it must have some problem that makes it deserving of the low multiple.

A company might be deserving of a low multiple because there is fraud, or they retain a management team that has decided to loot the coffers.  Although ironically fraudulent companies often earn praise and high multiples from the market until the day they fail, a la Valeant.

The stereotype of a value stock is a company producing shag carpeting run by managers wearing polyester suits with elbow pads who are wondering why sales are declining.  This can be the case sometimes, but it's more of an outlier than the norm.

I think the greater problem with Graham type stocks is they are in unattractive industries, and investors don't like to be out of step with the market.  I ran a screen for stocks trading below 75% of book value and for less than 10x earnings.  The resulting small list contained some sketchy biotech companies, a number of even sketchier Russian mining companies, as well as a few other resource and industrial companies.

These companies with depressed valuations don't appear in anyone's quarterly shareholder letter, and they aren't on WhaleWisdom.  In a perverse sense the increased socialization and ability to network with other investors via the Internet has made this problem worse.  I've heard of investors who search Twitter, Seeking Alpha and hedge fund letters for ideas.  If an idea isn't "approved" by someone well known in one of these circles it must not be worth researching.  The idea is that these high profile managers or prolific Internet posters spend all of their time reading and scouring nooks and crannies for stocks.  So they must have looked at everything already, and if they didn't buy it then it isn't worth buying.

Just because a name doesn't appear on Twitter, or in hedge fund letters, or on Seeking Alpha doesn't mean it's a bad idea, or it's not worth researching.  There are still plenty of areas that are inefficient, and stocks that are out of favor is the biggest area.

People like to be liked.  It's easy to be liked when you're doing the same thing as everyone else.  This is true for all aspects of life.  In sports-crazed cities it's difficult to cheer for an out of town team.  Groups of friends all have similar interests and views.  Political parties change direction often, but party followers keep toting the line.  The market is just a group of people too, and the market collectively likes things like any other group.  These likes and interests are echoed on TV, in letters, and in public speeches about investing.

Currently the market likes artificial intelligence, self-driving cars, automation, mail-order catalogs presented as websites (what is old is new again..Amazon the new Sears?), companies with high ROE's regardless of how they're generated, compounders and moats.  This wasn't always the case, at periods in the past the market's interests were different, and they'll change again in the future.  Yesterday's Nifty Fifty is today's IBM with investors running for the exists.

In large the market points in the correct general direction.  In the 1990s it pointed towards the Internet becoming a thing, it did become a thing.  In the 2000s it pointed towards financialization, which is still a thing.  The finer details aren't always correct, but the general direction usually is.

If a company isn't part of the cool kids club they might be able to float alongside for a while.  Maybe they'll toss a few keywords in their proxy about automation and technology innovation.  Or maybe their high ROE is good enough for a while.  But eventually those wannabes fall by the wayside.  Sentiment shifts and somehow a wannabe becomes a left behinder.  For years resource companies were the cool kids, now suddenly no one will touch them.  Airlines spent a long time in the ditch, but now they're suddenly cool again.  This is the popularity cycle at work.

One of the foundational concepts that Benjamin Graham taught was that there can be value where others don't believe it exists.  What he didn't say was "buy everything no one else likes."  He said to go poke where others aren't poking, because sometimes the baby is thrown out with the bathwater.

It's in these pools of dirty bathwater that deep value investors go searching for babies.  While the pool might be dirty the discovered baby isn't.  To beat an analogy to death.. the babies we're finding are cute and innocent, unsure of why they're laying on the street out the window in a puddle of bad water.

This is the essence of value investing.  Looking where others aren't looking, but sifting the bad from the good.  The idea is to find companies that have been marked by the market as bad that aren't.  Since these companies aren't bad like the market suggests, their goodness will eventually shine through for investors to notice.  When this happens their price will appreciate to be in line with other similar companies, not the mis-matched peers they were previously trading with.

Like everything in life investing is a popularity contest, and Graham style investing is not popular at the moment, just like the types of stocks it uncovers.  This doesn't mean the strategy isn't profitable.  It's actually the opposite, excess returns are found outside of the main stream of popularity.  I'd wager that a set of randomly selected set of companies trading at low P/B and low P/E ratios will outperform the FANG stocks, or Tesla over the next three to five years.  But this isn't a popular notion, and no one wants to be caught writing about a no-name value stock in their quarterly letter.  And that's why this opportunity exists.

1 comment:

  1. Asta Funding (ASFI) is one of these.

    ReplyDelete