Four Picks for the Get-Up-Off-the-Mat Value Investor

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Where has all the value investing gone?

If you go by the traditional definition championed by the late Benjamin Graham and his disciple Warren Buffett-that value investing involves assessing a company's intrinsic value and comparing it to such metrics as price-earnings and price-book ratios--you can see why the strategy has seen years of rough sledding. A recent article in The Wall Street Journal put it this way: "Hunting for cheap stocks has been out of favor for so long that some self-proclaimed 'value' investors are embracing a broader mandate, a potentially costly move in the later stages of an economic cycle."

Growth Versus Value

Growth investors typically look for companies growing faster than the broader market, stocks that are usually the subject of more buzz and are expected to maintain their growth for a while. But that same buzz can make investors prone to emotion, which can often times inflate valuations. By comparison, value investors are looking to invest in companies trading at a discount to the market-mature businesses with pricing power, modest growth, the kind that typically reward long-term shareholders with a dividend or stock repurchases. Value stocks generally carry the same level of enthusiasm as their growth counterparts, and the fact that they are value stocks usually means there are some dark clouds over their business that have investors concerned.

But not everyone agrees you have to take a side in the value vs. growth debate. Legendary value investor Warren Buffett takes issue with the notion that growth and value are contrasting approaches, which may in part explain his penchant for Apple (Berkshire recently upped its ante in the tech giant by a staggering 45% to 75 million shares, bringing its total stake to approximately 5%). While Apple's financial performance and innovative reputation place it firmly in the growth category, it is trading at 17.6 times earnings-not high compared to the current market P/E of 24.5 (based on S&P 500 as of June 8).

In 2000, Buffett made this argument in his letter to Berkshire Hathaway shareholders:

"Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation, except to the extent they provide clues to the amount and timing of cash flow into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component-usually a plus, sometimes a minus-in the value equation."

Historical performance of Growth vs Value

Growth investing-focusing on faster growing companies with richer valuations-has clearly been the better strategy during the past nine years of easy money, low interest rates and a steadily marching bull market. According to a recently Bloomberg article by Nir Kaissar, "The Russell 1000 Growth Index has beaten the Russell 1000 Value Index by 3.4 percentage points annually since 2007 through June, including dividends."

But markets move in cycles and, even with the relative outperformance of growth stocks in recent years, a reversion to value may be in the offing. In a report from Wells Fargo Asset Management, " The truth behind growth and value cycles ", we can get a sense for the cyclicality of value and growth stock leadership. Since 1979, there have been about 12 periods in which value outdid growth and 12 in which growth beat value. The piece also points out the length of the cycles tend to correspond with the length of the preceding trend. So for example, a long period of value over growth, at least historically, has been followed by a long period of growth over value.

Value Strategy Requires Tenacity

It's tough to stick to an investment strategy that doesn't bear fruit. But, despite long being overshadowed by growth investing strategies, value investors shouldn't throw in the towel. A tenacious mindset is what matters in value investing, a commonsense strategy rooted in the basic principle that if you pay modestly for a share in a strong business, there's upside down the road. Focusing on a company's fundamentals when evaluating investment opportunities allows an investor to filter out a lot of the noise concerning whether stock prices are too rich. It has also paved the road to riches for some of the most successful investors of all time.

At Validea, we use stock screening models that we created based on the strategies of some of the most successful investors of all time, including value legends Graham and Buffett as well as Martin Zweig, Kenneth Fisher and others. Using these models, I have identified the following four high-scoring stocks. This should be considered a starting point for most investors and as always individual stocks should be held as part of a diversified portfolio.

Credit Acceptance Corporation ( CACC ) offers financing programs that enable automobile dealers to sell vehicles to consumers. The company earns a perfect score from our Buffett-inspired stock screening model due to its earnings predictability and return-on-equity, which has averaged 31% over the last ten years (more than double the required level of 15%). Our Martin Zweig-based model favors the price-earnings ratio of 11.97.

Alliance Data Systems Corporation ( ADS ) provides data-driven marketing and loyalty solutions to consumer-based businesses in a range of industries and earns a perfect score from our Buffett-based screening model due to its ability to generate cash (free cash flow-per-share of $40.58). Management's use of retained earnings, which reflects a return of 15.4%, adds interest, along with consistently strong return-on-equity (10-year average of 32.1%).

United Natural Foods Inc. ( UNFI ) is a distributor and retailer of natural, organic and specialty products that scores well according to our Graham-inspired screen based on its revenue base (trailing 12-month sales of $9.9 million versus this model's required minimum of $1 billion), its liquidity (current ratio of 2.59) and its price-book ratio of 1.13. Our Fisher-based model also favors the company's leverage (debt-equity ratio of 26%).

British American Tobacco PLC ( BTI ) is a tobacco and next-generation products company that earns a perfect score from our Buffett-based model due to its predictable earnings, average 10-year return-on-equity of 35% (more than double the required level of 15%), and a decrease in shares outstanding in the current year (from 2.293 billion to 2,239 billion shares), which indicates management has been using excess capital to increase shareholder value.

John Reese and his clients are long CACC, ADS, UNFI, BTI.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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