The allure of deep value

Risks are growing along with valuations in the stock market. We check in on those who tend to shine at these times

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From the November 2016 issue of the magazine.

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(Illustration by Aleks Sennwald)

(Illustration by Aleks Sennwald)

Days into 2016, global equity markets flushed away more than a full year of gains. China was cratering and the global economy was headed into a tailspin. By February panicked investors watched helplessly as most major equity markets slid into correction territory. Bear markets typically take 14 months to work themselves out and years to recover. This time it took only 24 days.

Investors got lucky, but it should be a wake-up call considering the present investing climate. Minus the blip in January, the U.S. bull market has charged ahead largely unabated while the S&P/TSX Composite, devoid of any significant economic drivers, rallied 12% higher. It should come as no surprise that the spectre of another shock weighs on the most seasoned investors’ minds. That’s not fear mongering; on a price-to-earnings basis U.S. equities, as a whole, are now the most expensive they’ve been since 2009.

Greed is the enemy in this environment. Investors need to resist the temptation of taking on more risk in the faint hope of eking out a little more return. It’s a good time to go defensive with value. But would you rather pluck from the same small pool of stocks everyone else is buying—or go fishing with some deep-value fund managers who have a tendency to outperform in down markets?

Generating returns good markets and bad

Francis Chou has won awards for his ability to perform in good markets and bad. His current portfolio in the Chou Associates Fund is a motley crew of market cast-offs, including Valeant, Sears and Resolute Forest Products. These are not the sort of companies that scream safety; if anything they look to be what the investment community calls falling knives. But Chou sees them as deep value plays and he’s taken the time to methodically come up with his own valuation to help him catch them safely at the right time—short term losses are a hazard, but that doesn’t faze Chou.

Whether you agree with Chou’s holdings or not (and given his track record you may want to give him the benefit of the doubt) this isn’t the first time he’s held such out-of-favour stocks in a challenging environment.

Why active strategies may have an edge

Jennifer Radman is another manager who performs better when the broader index declines. Since launching the Caldwell Canadian Value Momentum fund five years ago, her fund has outperformed in 75% of the down months. She, too, stresses the need for caution in this environment, which is why she thinks active strategies have the edge right now. “For passive strategies to work you need broad-based economic growth or you need valuations coming off lows and as we sit here today and look forward we don’t see any of those scenarios,” she argues.

Most notably, her portfolio is devoid of telecoms or financials, which are the traditional high-yield safe havens for investors. Her reasoning: Everyone is shopping for the same “safe” stocks, which has made them expensive. Instead she focuses on a company’s cash flow yield, whether they pay it out as a dividend or not, to see if it’s growing and higher than bond yields. She also wants to see a catalyst, like a sector consolidation or a company finding new efficiencies, to sustain the positive momentum on a stock. New Flyer Industries epitomizes her strategy. The Winnipeg-based bus manufacturer survived as its competitors abandoned the market in recent years. Over that time it has become more efficient, which gives it an edge now that demand is returning.

It all comes down to knowing why you hold a particular stock in the first place. Sometimes investors can get away without a strong conviction behind a stock, but given market valuations now, this is likely to not be one of those times.

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