Personal Finance: Are value stocks due for a recovery?

Personal Finance: Are value stocks due for a recovery?

December 9th, 2015 by Christopher Hopkins in Business Diary

Although such distinctions are admittedly simplistic, it is nonetheless useful to divide investment philosophies broadly into two camps: value and growth. Value investing attempts to identify companies whose stocks are undervalued today based upon a conservative estimate of assets and earning power, with little emphasis on prognostication of future cash flows or sales trends. Growth investing (again oversimplified) attempts to capture the present value of projected future growth. In theory, growth investors have the right idea, as the intrinsic value of any investment is identically equal to the present value of all of its future cash flows. Problem is, that pesky word "future."It turns out that very few people are actually any good at forecasting. In the words of financial sage Yogi Berra, "it's tough to make predictions, especially about the future."

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In actual practice, the value approach to stock analysis tends to beat growth investing over time, mostly because it is indeed impossible to accurately forecast distant cash flows. But while value investors can steadfastly hold to the long-run superiority of their approach, they sometimes find themselves lost in the wilderness for long periods of time. This is one of those times.

The divergence has rarely been so great. So far in 2015, the Russell 1000 Growth index is up 7.3 percent, while the Russell 1000 Value index has lost 2.4 percent, a difference of nearly 10 percentage points, the largest discrepancy since the tech boom of the late 90s. Such a period of underperformance can make it difficult to stick with a discipline that does not appear to be working at the present. Patience will be rewarded, but gratification can sometimes be delayed.

Will 2016 witness the revenge of the value nerds? Maybe (again humbly discounting the value of prediction). A recent example may serve as a harbinger of a migration back to fundamental valuation.

Chipotle Mexican Grill reigned as a favorite pick among restaurant analysts in the "fast casual" segment, with universally favorable opinions and a lofty stock price to match. As of early October 2015, the average analyst following the company predicted a 20 percent growth in profits every year for at least the next 5 years. Based upon that aggressive expectation, the stock traded at $750 per share, yet almost all analysts maintained "buy" recommendations (Wall Street's equivalent of a 3 star Michelin rating). In order to buy the stock at that price, one must expect actual results to be substantially better than the already optimistic predictions. For that to happen, everything had to go just right.

Well. Fast forward 15 days to late October. Early reports of an E. coli outbreak at Chipotle stores in the Northwest ultimately expanded into a crisis involving restaurants in nine states, prompting the company to publicly slash its guidance on future profits. When a stock is priced to perfection and fails to surpass expectations, investors are left with a bad taste. In this case, downright rancid, as the stock has swooned 30 percent to $526 per share as of Monday.

Of course, stock analysts cannot be held accountable for an unpredictable outbreak of a bacterial infection. But that is precisely the point; long term forecasts of sales, profits and growth rates impart an illusion of precision but are inherently uncertain. When stock prices today reflect perfect knowledge of the future, the potential for a negative outcome is magnified.

It may still be premature to suggest that a rotation in favor value is imminent, but the recent spate of disappointments among the high-fliers and the relative underperformance of value stocks suggest the possibility. No predictions though.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.