Value Investing and the Philosopher’s Stone

By Kevin Simms, Joseph G. Paul April 25, 2013

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.

Value Investing and the Philosopher’s Stone
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