Why now is the right time for value investing

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As growth investing dominated the investing narrative in recent years, the message of value investing was often drowned out. But as high interest rates and economic headwinds are taking their toll, growth investing has lost some of its shine. Vito Maida, president and portfolio manager, and Mansur Khan, vice president, research at Patient Capital explain why value investing strategies offer a viable and timeless alternative.

CFO: What’s been the challenge for value investing in a period dominated by growth investing?

VM: Recency bias is human nature. If investors are seeing other investors make a lot of money in the short to medium term, they will ascribe positive characteristics to that type of wealth generation, irrespective of how it’s achieved.

CFO: Why have higher interest rates changed the picture for growth stocks?

MK: Higher interest rates tend to act as gravity on valuations across the board. Some of the higher-growth, momentum-type speculative names, like the Pelotons and the Ubers, may have been quite popular in a low rate environment, but they tend to get hit much harder when rates are high.

CFO: How does Patient Capital provide better returns in a higher-rate environment?

MK: Our portfolio is concentrated in no more than 20 high quality businesses that are fundamentally sound, and that were trading at a 40 to 50 per cent discount from their intrinsic value. There’s an absence of those high-flying momentum stocks and we believe that these considerations position us quite well in this newer environment where rates are likely to stay elevated for some time.

CFO: How would your investment review process screen out companies like Peloton and Uber?

MK: Number one, we pay a lot of attention to the sustainability of cash flows. Do they cover all the capital expenditures and all the required cash outflows of the business? A lot of those companies would screen themselves out at first glance because they don’t have the cash flows to meet those requirements. In terms of valuation, we also look at a 40 to 50 per cent discount rate to intrinsic value as our entry point. These criteria  would screen out the vast majority of those companies that don’t have strong fundamentals and/or are overvalued.

CFO: How did this strategy carry you through the 2008 financial crisis?

VM: Starting off in 2005 and 2006, the market started to get concerned about mortgages and real estate. As the market was rising and some of our stocks reached their sell target, we started to exit many of our securities. In 2008, as the bubble burst, we entered the financial crisis with 80 to 85 per cent of our investment in T-Bills. It wasn’t a market call, or something we had predicted would happen. It’s just that our discipline led us to that portfolio position. We sold everything that we owned that had reached intrinsic value, and we couldn’t find anything to buy that met our criteria. While the markets and most other investors experienced substantial losses in 2008 we generated a positive return.

CFO: How did Patient Capital negotiate the ensuing low interest environment?

VM: When interest rates are effectively zero, speculation runs rampant and market valuations reach extra-ordinary levels. That’s a challenging environment for value investing and characteristically we underperform in a down market.

CFO: And then interest rates began to rise…

MK: We began to recover nicely after the pandemic. With today’s rising interest rates, we think it’s only a matter of time before valuations become normalized.

CFO: Why do you see the current period as the right time for value investing?

VM: We believe that interest rates and valuations are intrinsically linked. Today the S&P 500 is trading at about 25 times earnings. The long term average is 14.5 to 16 times. At the same time, the AAA Corporate Bond rate is about 5.5 per cent; close to its long-term average of 6 per cent.  If you believe in the thesis that valuations are intrinsically related to interest rates, the market P/E multiple should come down from 25x to about 15x — a dramatic drop of about 40 per cent.

We believe that as rates normalize and stay higher for longer, a combination of high discount rates, lower multiples and lower business growth rates will reduce the valuation of growth companies dramatically. In a down market like this with a potential recession looming, an absolute value-based strategy tends to outperform and work to protect and preserve capital, whereas investing in expensive growth companies will likely lead to a permanent loss of capital.

MK: If you do it right and you’re also buying stock offering above-average dividend yields, it should generate a better-than-average long-term rate of return and provide downside protection in a down market. At the same time, when market volatility is apparent, people tend to flock to safer-type stocks and value investing typically outperforms.

CFO: Are you seeing sufficient value investing opportunities today?

VM: The high quality businesses that we would like to own are still trading substantially above our target purchase prices, so right now we’re still at approximately 40 per cent cash. But given all of the factors that are trending favourably for value investing, we believe it’s the right time for investors to position themselves for opportunities to achieve excellent risk-adjusted rates of return over the long haul.

Lysander Funds offers the Lysander-Patient Capital Equity Fund, Series A and Series F, managed by Patient Capital.

For more information on Patient Capital Management, visit: https://patientcapital.com.

For more information on Lysander Funds, visit: www.lysanderfunds.com

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