Discounting Future Prospects
In one sense, among value managers, I’m an agnostic. I am more than happy to analyze the theories of other value managers, and see how they can help me create an even better method for analyzing stocks.
But in the present environment, many value managers have gotten hit, and hard. Thus the need for a Value Support Group. I sympathize with their plight, but value has to be sought considering the likelihood of problems in earnings prospects.
Now, I’m not perfect, and sometimes after underperforming days like today, I wonder if I should be writing at all 
, but part of being a value manager should be looking at the future prospects of the industry one is investing in. Banks and other credit-sensitive financials are staple investments of value managers, because they are mature businesses, with good returns on equity under normal conditions. Trouble is, conditions aren’t normal, and I can’t imagine how many times I beat the drum over at RealMoney, explaining from 2004-2007 why financials (away from insurers) would eventually have trouble.
As a value manager, I am doing well this year, because I largely avoided credit-sensitive names, and was more willing to believe that the economy wasn’t doing that badly. Value investing means looking at both the long and short term prospects for an industry, as well as the valuation. Industries that have gotten smashed on a price basis, but have reasonable long-term fundamentals can be a fruitful place to invest. Industries with low P/Es, but have deteriorating fundamentals are usually bad places to invest. Industries like newspapers, where the long-term fundamentals are bad, are bad places to invest, regardless of valuation, unless there are non-newspaper assets.
Ideally, I invest in industries that have been smashed, but the long term fundamentals are decent; I buy high quality names that can survive. Less ideally, I buy companies that are relatively cheap, where trends are under-discounted. This is not a perfect way to invest, but it does tend to yield good results over time, with a decent amount of noise in the results.
In summary, value investors should not be wedded to a few sectors, but should be willing to abandon sectors that were previously regarded as key if the situation is bleak enough, and valuations are too high.
August 5th, 20089:53 am at
David,
I agree with you about assessing future prospects for an industry. However, from a fundamental perspective, aren’t you introducing an element of timng? Theoretically at least, at the beginning of a recession, “the situation is bleak enough, and valuations are too high” for most industries. The practical element is being able to forecast a recession. Economists have a poor track record at doing that.
One group has made accurate forecasts–The Economic Cycle Research Institute (ECRI). I know you do not try to time the market, but if you could forecast a recession, isn’t that what your current post implies?
August 5th, 200810:03 am at
David, one of your Investing Rules is:
“Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.”
It seems that choosing the right value metric for a specific industry would be an important piece of the analytic process.
Would you be willing to discuss the topic of how you have determined which value metrics to use for which industries and industry groups?