Value and Rebalancing

The temptation is strong. The strategy you have used for years has underperformed. Why take the risk? Move back to the benchmark. Like a remake of a classic film, we have seen most of this before. In early 2009, pressure was on value stock managers to change their stripes. We recall a conversation from April 2009 with a foundation client invested in our Large Cap Value strategy. We had recently rolled to a new portfolio, and one of the selections was Wyndham Hotels. They were quite agitated – after the financial crisis it was unlikely that people would be going back to hotels for years. How could we? I took the quant’s way out of the question – “the model made me do it.” Wyndham was the best performing stock in the S&P 500 over the next 12 months.

The current reckoning certainly rhymes with the financial crisis. We must confess that even our conviction was challenged this time, and I promise you, ours runs deeper than most. Last week it was time to roll our value portfolio forward. Put the names back into the hat, take a fresh look, buy what is cheapest based on the models and caveats we employ. To add to the insult, it was also time to rebalance our multi-asset portfolios. What this meant was we had to buy a portfolio of decimated value names, in some cases buy more of them. Alaska Air? Kohl’s? Valero? MGM? Who is going to fly, go to a department store, get gas or gamble? Sure, these stocks have never really been cheaper, but come on. This is wake up in the middle of the night with these ticker symbols swirling in your head stuff. And you want us to buy more!

Take a deep breath. Think for a minute. What works? Buy when others are selling, sell when others are buying. Buy zero coupon bonds in the early 1980’s. Sell tech and buy value in 2000 (value was “broken” then, too). Sell crude at $150 (that’s when people stop buying gas). Value stocks look like that right now. They have discounted the end of air travel, retail, gasoline, and gambling. Never again will there be cash flow or dividends. We aren’t blind, we get that the near term is difficult for these names. But does that justify low single digit PEs? Or should it be mid-single digit PEs? Or can you look forward a few years and imagine a world different than today. For at least part of your portfolio, don’t you need to own the cheapest assets in the world? Rebalancing works best when you have volatile assets with low correlation and positive return – pump that volatility. What you shouldn’t do is sort by near term returns top to bottom and pile into the biggest winners. That’s not a portfolio.

Value stocks at this juncture are incredibly cheap. We aren’t the first people to say this, but it bears repeating nonetheless. The chart below shows the ratio of S&P Growth PE ratios to S&P Value PE ratios. There are bargains galore on offer, right now. Great businesses that are temporarily troubled and are being penalized to extreme degrees. Take advantage of it.

RatioSPGrowthValuePE

Data Source: Bloomberg, Mount Lucas LP