October 05, 2020

VIDEO: Institutional Investors Forum | Is Value Dead?

On September 29, 2020, we hosted our first virtual Institutional Investor Forum for clients in which Institutional Portfolio Managers Perry Teperson and Lisa Meger addressed the question, “Is Value Dead?” We are pleased to share a video replay of the event below, along with an edited transcript. If you would like a copy of the slides, please contact your portfolio manager or reach out to Mike Wallberg at mikew@leithwheeler.com.

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Lisa Meger (LM) - Welcome (0:00-2:44): Hello everyone. Thank you for joining us today for our Institutional Investor Forum. We wish we could be hosting this event in person as we've done these last few years, but it's good to be connecting with you all virtually. My name is Lisa Meger, and I am a Portfolio Manager on the Institutional Team here at Leith Wheeler. I will be your host today as Perry Teperson leads the discussion on, “Is Value Investing Dead?”

Recent market performance has been dominated by the likes of Shopify and the ever-evolving acronym… First it started off as FAANG, then FANMAG, and more recently I've heard FATMAN, which includes Tesla in that group. With Value out of favour, we'll talk about the similarities and differences between the two styles, and ultimately why we believe our Value approach will generate strong returns for clients over the long term.

Perry's experience working with institutional clients for the last 16 years here at Leith Wheeler, and in his previous roles as a Consultant and Actuary, and also serving on a foundation board himself, give him some unique insights into this topic. Before jumping in, a few housekeeping items I wanted to go over with you. We'll spend about 35 minutes on the presentation today, and then have time for Q&A, after.

[Webinar instructions edited out for space.]

Perry Teperson (PT) – Introduction (02:44): Thank you, Lisa. And hello, everybody.

[Introductory comments edited out for space.]

PT – Page 2 (04:08):

The topic, “Is Value Dead?” obviously has become more prominent recently because of recent performance. Let me take a moment to review why this topic is so prevalent today. What I've done here is I've taken a slice of the markets in two decades, the first decade being the decade of the 2000s and the second decade being the most recent one, the 2010s. And what you see here is, you see two distinct performance patterns.

The first 10 years, Value had the upper hand: the Russell 1000 Value Index saw large-cap Value stocks in the United States pretty much treaded water, but large-cap Growth stocks returned negative seven for 10 years running, which gave Value a significant edge, although most of that edge occurred in the first two to three years. The second decade, Growth has had a significant edge, up about 18% versus Value up about 14%. But again, the extent of the edge only occurred really at the end of the period in the last few years, three to four years.

And there's really a 12 to 14-year period in 20 years of data, where Growth and Value are pretty well neck and neck. On a cumulative basis over the full 20 years, Value still has the edge because of the struggles that Growth had in the early 2000s. Six and a half versus four and a half. But we're not including here the experience in 2020, when Value has continued to lag for obvious reasons, see the pandemic, which we're aware of, and we've reviewed this with many of you. Truly the pandemic event was like being hit by a meteor from space for managers.

PT - Page 3 (05:08):

We had businesses which were typically resilient, expected to be resilient during a normal recession, but ultimately land to halt during a period of time when consumers went home and stopped spending. Companies that were in the consumer sector, that were in the financial sector, the materials and energy sector, completely froze up and were sharply valued downwards in the marketplace.

And the stocks which had done quite well in the last few years, large cap Growth stocks, particularly the stay-at-home stocks, stocks that benefit from us using Netflix, going online, shopping, Amazon, surfing the web, Google, Facebook, all did very well during a time when the Value stocks did extremely poorly. And that is ultimately what has led to the assertion that Value is dead.

PT - Page 4 (06:50):

In the last 10 years, I will further break the period up into two pieces. The first six, and then the final four. Now, in the first six years, Russell 1000 saw large cap stocks in the U.S. to be very similar to the S&P 500. They rose about 19% per annum for six years running. Value stocks trailed a little, up about 18%, and Growth stocks beat the other side of that, up about 20%. Now, those three patterns of performance, I'm not sure exactly how they land on you, but I look at those three equity portfolios as delivering roughly similar results.

As an example, we have three Canadian equity strategies at Leith Wheeler. We've got our flagship or best ideas portfolio; we have one which is more high-dividend-focused; and we have one which is carbon constrained, with much less carbon exposure. All three equity portfolios are driven off the same research process, with some nuances and differences between the three. And I would expect, in a given six year period, you might see something like this pattern of performance from those three equity portfolios.

There's nothing in that data which leads me to believe that there's a material difference in the way the portfolios are built, or that something materially different is about to unwind. The unwinding occurred in the last four years, though. A period where large-cap Growth stocks had a significant upper hand, up about 21%. And then, painfully for us as Value managers, the large cap Value space was only up about 6%. So the suggestion that Value has struggled for a decade, I don't think is accurate. I think it is accurate, though, that Value stocks have struggled in the last four years.

PT - Page 5 (08:43):

Now, I'm going to switch gears for a second, having shown some of the reasons why you've luckily dialed into this webinar today, to talk about investing in a more general sense. Now, when we buy a company, we're buying a business with the aim of benefiting from the cash flow and earnings power and ability to generate and grow that in the future. We're not preoccupied when we buy the stock with selling it, but we are aware that there could be an exit point in the future.

And at that point, we would expect a future buyer to make the same assessment at that time in the future. Look at that business, consider its future earnings power from that point on, and future cash flows, and make an assessment whether we're selling it to them at a reasonable price.

If you buy a business without any regard to those cash flows, simply with the hope of selling it on at a higher price in the future to somebody else, that's a Greater Fool Theory. That's the theory that there's going to be a bigger fool in the future, who's prepared to buy that company from you at any price, something which we lived and experienced firsthand during the tech bubble. So, those future cash flows are important to any professional investor, both the Value and the Growth manager are preoccupied because neither are speculating.

PT - Page 6 (10:07):

If they're good at their craft, and they're fundamentally good bottom-up Value or Growth managers, they're making assessments of those future cash flows. It's best put by Warren Buffett. When we buy a business and try to determine a sensible valuation for that business, we are thinking very carefully about the growth potential and earnings power of that business.

Warren Buffett's quote is that this growth variable can range from being fairly unimportant – maybe you're buying a pretty mature business which doesn't have a lot of growth potential, maybe a lot of its cash flows are contracted, in other words, set for a period of time with some reset in the future – that type of business might not have a large growth variable baked into the valuation. Some other companies that you buy might have an enormous amount of growth that's baked into the valuation.

Even a company that's growing by acquisition, you might buy that business because of its merger and acquisition thesis, because of its plan to extend its reach further into the world. And growth would be very important to you as a Value manager in assessing the price potential in the future, and the valid or reasonable price for going in today.

This term “Value investing,” Warren Buffett suggests is redundant. It should just be investing. I’m not fond of reading quotes during presentations, but I think this quote is worth reading. "What is 'investing' if it's not the act of seeking value to justify the amount that you pay?" If I've said to you, "Collapse all of your investments and let's go into business together to either buy a building or buy one business," we would spend an awful long period of time assessing the price of that transaction, and whether we thought it was going to pay off in the future. It could be a critical variable, frankly, in our assessment of whether we're going to do well or not well.

PT - Page 7 (12:04):

You probably weren't expecting a lot of math in this presentation. This is the first week of actuarial school brought down in one slide. The net present value calculation, the value of a business, the value of your pension plans, liabilities if you're a pension trustee, the value of how much you need today, if you're an individual setting aside money for your retirement, is based on a formula like this.

It's based on the cash flow that we want, either we need as a pension plan, or the cash flow we think a business can generate, divided by some discount rate formula, which factors in both the rate of required return and the growth potential of that business. The growth assumption is a critical component of that formula.

This is why if you're a pension trustee and the actuary comes in and says, "We're reducing the discount rate," that's the first item in the bottom of that calculation, where there's average cost of capital, you would just replace that with the discount rate for a pension calculation. If you use a lower discount rate, you use a lower number at the bottom, which is the denominator and a lower denominator produces a bigger number. So the values have gone up of your pension liabilities.

PT (13:23):

Now, identical to a Growth investor, a Value investor focuses on all of those variables, the one difference being that a Value investor might, on average, prefer to focus on businesses that have a higher certainty of free cash flow, a higher record of profitability, a more established business. They like growth, we want growth, but we're going to make, perhaps at the margin, more modest assumptions. We're going to be more careful, more cautious about the growth assumption that we're using… whereas the Growth manager is happy to pay up for a business that has big growth potential. They'll typically have businesses in their focus that have higher earnings growth – not to suggest that we, as Value managers, don't look at high earnings growth businesses – [but] they would probably have more of them. They're not too worried about the certainty of free cash flow. In fact, they want the certainty of a business, that's not in some decline, or as we point out on this slide, a company that's involved in making buggy whips or something of that nature.

But both groups of investors, Value and Growth alike, can do well if they find companies where through some edge that they have in their research, can outperform these assumptions. So, if they find a business that is trading at a price which is below this fair value assessment, there's an opportunity to make money. And the Value manager might come at it by finding a business that, in their assessment, has a higher free cash flow than the market is assuming, or higher growth than the market is assuming –because there are many Value businesses that have growth potential, but that potential is simply not being recognized by the market. A Growth investor will make money if they find companies that have even higher growth than what is currently baked into the market's assumptions. So, where do you run into problems?

Well, if you're a Value manager, you want to avoid a value trap. You want to avoid those buggy whip companies, you want to avoid those companies that have free cash flow, but that free cash flow might be in some decline. So, you're very attuned to that risk. If you're a Growth manager, you want to avoid the growth trap. And the growth trap is a business that the price implies a high level of earnings growth, but the earnings growth ultimately disappoints. So, there's risks for both sets of managers doing these calculations.

PT - Page 8 (15:58):

So, what is the difference? We'd like to find businesses that we believe are being viewed too pessimistically by the market. The market feels the glass is half empty. Growth investors like to find businesses where there may be some optimism, but it isn't even enough optimism. There's going to be even more growth than what is priced into the markets. The market might be looking at it as a glass half full, but the Growth investor is finding even more potential.

These are not massively different assessments, but they're just different nuances of a similar process and a similar attempt to find decent value.

PT - Page 9 (16:45):

Let's look for a moment at a name that we're all familiar with. Apparently, Amazon Prime currently has penetration among US households, which is, well, above 80%, if some of the numbers that are there are to be believed.

But there was a poor time to buy Amazon, and it was in the late 1990s. In the late 1990s, I think there was no earnings, there wasn't a PE. And if you had bought it at the prevailing prices, you were assuming an exceptional decade of growth that was expected to follow in the 2002 to 2009 period. What actually happened in that period, 2002 to 2009 was that growth was spectacular. Sales growth grew by more than 30% per annum for 10 years, but the stock didn't deliver. The stock went up by just under 6% per year, over that period of time.

Starting price mattered. The market had already discounted a fantastic expected level of growth, and that level of growth was fully baked into the stock price, so buying Amazon in the late 90s was a losing proposition. You would have been way better off just buying a basket of Value stocks for sure.

But there was a time when buying Amazon was hugely successful. In the 2009 period, Amazon was valued at very reasonable multiples. If you had anticipated that they would simply replicate their prior decade of growth, or even fall a bit shorter that decade of growth, you would have done superbly well. In that 10 year period, sales actually grew at a slightly lower rate of about 28% per annum, average growth, which is still explosive, but the return over that period was fabulous, it was a 30% return per year. So, value mattered. This is a growth business where value mattered. The value was simply not there in the late 90s, and it was there significantly in the '09 period.

PT - Page 10 (18:45):

Let's look at a Value stock where growth mattered. This is a stock in Canada, Magna Auto Parts business. It's always cheap. It's always offering what we would call cheap statistical value. You're on your screens on Value metrics, it pops up. If you'd bought Value in the late ’90s, anticipating only modest growth... the problem was, in the decade that followed, the business shrunk on an earnings basis. Earnings actually fell. It was negative for that decade, and the return was also negative. The fact that the business didn't deliver any growth in that decade was a problem for anybody who owned Magna, even though it was cheap when you began investing in it in the late ’90s.

The market hadn't really discounted that decline in earnings. It looks like a value trap. But there was a time to own Magna and it was 10 years later. At the end of the 2000s period, Magna was trading at its usual cheap level, but the following decade, it actually delivered massive earnings growth, pretty similar to the earnings growth that Amazon experienced, 27% per year. And the return over that period was very favourable for Magna investors. This is a Value stock where growth mattered. It wasn't there in the first 10 years, it was there in the second 10 years.

PT - Page 11 (20:09):

Now, these valuation calculations –  that “present value” calculation with the cash flow on the top and the discount rates on the bottom... Once you get that value, we often divide that value by the earnings to get a price per dollar of earnings. And this is something which we talk about in our meetings with you. We talk about our portfolios and what the P/E ratio is of that portfolio. It's really this valuation shortcut, because it's taking that first calculation, the valuation, which as I've mentioned, embeds a post of assumptions there about the cash flow of the business, the earnings of the business, and appropriate discount rates.

You could have two investors, a Growth and a Value investor looking at a business, which has some sales – in this example, they've got a couple billion dollars in sales, it's got no free cash flow, it's spending a lot of money on its business to generate those sales, and those expenses are putting the cash flow down to zero in this case. And you might run a model and develop a bunch of assumptions, and assume that in three years time, this company is actually going to trade at 50 times free cash flow, with positive free cash flow in that period.

And you'd be making a set of assumptions we've shown in the blue bubble here. I won’t read them all, but they essentially refer to significant revenue growth for the first three years, which then starts to slow down. Margins which start off fairly small but ramp up as the business becomes more efficient, and then after year 10, this business slows to a more steady pace, which is in line with many of its peers in the market.

And you might run the model and put a valuation on it. And the Growth manager might say, "This is a reasonable set of assumptions." And he might buy that stock. A Value manager will do the same assessment and say, "Well, that seems pretty optimistic. We really don't want to make a big bet on that.” And we'll only know in 10 years time which of these two managers are correct, ultimately.

PT - Page 12 (22:10):

Why is there a Value gap? Why is there a gap that we identified earlier on in our presentation where in the last four years Growth has significantly exceeded Value? Well, the fact is, that large cap Growth companies in the US have been very profitable. They've grown their business faster than expected. They've got terrific balance sheets, they've been able to use those balance sheets to buy back stock in an era of low interest rates, and that financial transaction works very well in the favour of shareholders. And they've also further benefited in the first quarter of this year, because many of them are technology companies, which benefited from the stay-at-home trade. Much more streaming going on, people are watching more Netflix and more YouTube. That data has to be stored on servers. Anybody in the service, and streaming, and data business is doing well, and anybody that's involved in the online clicking is doing well, because advertising revenue is shifting more and more to digital. It's been a wonderful ride for those in digital, and it's a comfortable narrative. Growth has worked really well. Momentum has certainly continued. There's a lot of flows into ETFs, into passive funds and the valuations have been stretched.

The narrative continues significantly, and everything feeds into this narrative. When you've got friends who are asking you about whether it makes sense to buy Tesla, it feels a lot like the days of the tech bubble, where the taxi drivers were talking about technology stocks and how excited they were to get into the market. At some point, though, we have to step back and say, "Look, this has happened, it's in the past. Where are we now? We want to go forward. Is this trade crowded?"

PT - Page 13 (24:00):

Let's look at some data and actually let's begin by conceding that the area of the market for large-cap Growth stocks has justifiably been rising because they have been more profitable. On the left hand side, you have the price-to-book of the Growth companies, the Value companies, and then the market as a whole, Growth being in blue, Value being in pink, and the market being in gray. And you can see the price-to-books have been expanding from 2010 to 2020, a period of low interest rates, a period of very average or modest economic growth.

So anything which exhibits superior earnings growth, the market has become more and more excited by. On the right hand side, you can see that Growth companies always have a superior return of investment to the market and to Value, and that has continued. In fact, it's widened because you can see the blue line ticking up a little bit more, whereas the other one is going up by, ever so slightly less. So, you can see that in this decade, Growth companies have become more and more profitable in this period, but the valuation has also gone up.

PT - Page 14 (25:15):

The next slide attempts to address whether the valuation has gone up beyond what's reasonable. So, in our opinion, large-cap Growth stocks are exhibiting valuation levels that are rather stretched. This study was done by a group called Empirical Research. They looked at the 75 top growers in the market. A lot of names there you will be familiar with, many of them would be names that are in the FAANGs, so you've got the likes of Apple, and Amazon, Google, and Microsoft in there, but you've also got many other businesses in there which are trading at very, very lofty valuations, and they would also be very fast growers. Names like Beyond Meat, and Shopify, and Tesla would be in this group.

If we compare where we were at the end of June, to where we were in the late 1990s, and where we were in the early ’70s and late ’60s... this period looks to be the second-most expensive out of those four, or the most expensive out of those four by a long shot, depending on how we make this analysis. The first way that we would analyze it is we would give a higher weight in the calculation to the largest companies. A company like Google, or Microsoft, or Apple is going to have a much bigger influence in the average calculation, if you do it on a capitalization weighted basis. And a company, perhaps a small company compared to be like Beyond Meat, is going to have a much smaller contribution to the average calculation than an Apple. On that basis, look at the black charts. Stock still look, priced on a trailing P/E multiple basis, around 50 times earnings, not quite as lofty as the late ’90s, which hits 80x, but higher than the Nifty 50 period in the late ’60s, early ’70s.

If you do it on equally weight basis, so you don't give Apple a much higher weight and the calculation, this group is trading at more than a hundred times earnings, which is even greater than it was in the late ’90s.

So, these are stretched valuations. Despite the fact that we tip our hat to the earnings growth that has been achieved by the likes of Microsoft, and their ability to generate cash flow and be profitable in the last five years. We suggest picking up the theme from the early part of the presentation, that there is a price at which you'd own that business, which makes a lot of sense, and there is a price which makes less sense. Stretched valuations certainly suggest the prices make a lot less sense to us as Value managers.

PT - Page 15 (28:12):

Another calculation of a similar nature, is one which looks back all the way to the 1920s, the period of the Great Depression, and looks at the levels of most expensive stocks and the levels of the cheapest stocks. It looks at the differences in those levels and whether right now it looks about average, more expensive than average, or really more expensive than average measured by the number of standard deviations that we're observing. And the standard deviations that we're observing now is in the three times range.

All that means is that this is extremely rare. If we were to look at the past behaviour of the most and least expensive, it just doesn't create such a wide dispersion in results as it has done in the last four years, leading to the point where we were earlier this year, in March. And in terms of a “three standard deviation event,” or maybe you hear this jargon, the “three-sigma event”… we're pretty well living a three standard deviation event. The fact that unfortunately we've gone home, the fact that we're going through periods of isolation, where our spending habits have changed dramatically. The fact that you haven't had a global pandemic since 1918 tells you that this is something like a two or three-sigma event hopefully. We don't know what the next 100 years are going to bring, but hopefully there won't be something of this nature more than once, if at all.

And a point that perhaps I didn't make early on in the presentation, but it goes back to the early material of those two decades.

PT - Back to Slide 2 (30:20):

Remember we looked at two separate decades and we found that Value was ahead of Growth for a few years dramatically. And then Growth was ahead of Value for a few years dramatically. Usually, what happens is that the difference between Value and Growth isn't that important for a stock investor. When the differences between Value and Growth are closer, it's much more about your ability to be successful as the stock picker for an active manager than it is, whether you're more Value-focused or more Growth-focused. If you're a good Value manager and you add a lot of value versus your basket of Value stocks, you can also, at the same time, add a lot of value versus the broad markets and versus Growth stocks, because the differences between the two really aren't that pronounced.

In fact, 70, 80% of the time, the differences aren't that pronounced, then you get something like 10% of the time to 20% of the time, the differences are pronounced, sometimes quite severely, sometimes in favour of Value, sometimes in favour of Growth, but those have never persisted in the past and we don't think that they're going to persist again.

PT - Back to Page 15 (31:18):

This spread in valuation, which has happened to that level about four or five times and certainly that extreme, maybe two or three times, hasn't happened since the 1930s. And what's going on today has some parallels to the 1930s. You have a lot of money printing, a rescue by the federal governments around the world, you have periods of just quiet, and unrest, and then angst going on at the same time, and you've had an economic collapse, but this time it wasn't because of an economic reason or because of risk taking, which was the case in the ’30s. In the late ’20s, there was a lot of excessive leverage and risk taking, financial speculation. In this case there wasn't. It was because of the reason that we all know, everyone knows so clearly, the coronavirus.

PT - Page 16 (32:21):

Now, in the last four years or so, Growth stocks have had a significant P/E multiple expansion. Growth stocks would typically trade ... Have a look at the top part of this slide here: Russell 1000 Growth, P/E (price-to-earnings - next 12 months)... So those forward price-to earnings multiples are ticking around 30x earnings whereas usually, they bounce around between, let's say 16, 17 to 21x, always at a premium to Value stocks, but never at this much of a premium where they're trading at 30x.

And the relative value of that premium is shown below in blue. The Growth basket versus the Russell 1000 Value basket, is trading at about a 1.6: 60% more expensive whereas usually it hovers around 20%, maybe 30% more expensive if you go back and maybe even less than that, whereas now there's a 60% valuation expansion, which tells us that investors are simply prepared to pay higher and higher multiples for the promise of future growth.

Remember going back to our equation earlier… cash flow from the business divided by discount rate and its future growth that's embedded in that calculation – not post-growth, that's behind us. Investors are paying up more for the expectation of continued superior future growth.

PT - Back to Page 14 (34:09):

And the reading that I've done on this group here, the big growers, suggests that, that group on average, the assumptions are that it will deliver growth somewhere in the region of about 12 to 13% per annum compounded, on average, for the next decade.

Now, that seems pretty stretched. Historically, going back to the ’60s, only one in three companies have been able to deliver that level of growth. So, to own that basket of Growth stocks and get it right, you have to be very successful at picking the ones that are the most capable of delivering superior growth, and frankly, the most capable of outperforming the assumptions embedded in those valuations, Shopify being a great local example of this.

PT - Page 17 (34:54):

Shopify, a business that's local to us in Canada. We finally have a name in Canada, which gives us that Amazon story. It's a filled with dreams. It's built on the premise that they have a market-leading technological advantage, and a terrific platform to continue to grow their business. But looking forward, we believe that they have to grow their business by something like 40% per year for the next decade, to justify the current price.

And it's just such a lofty goal that the chances of them achieving that are, well, not zero, are slim. The chances of them achieving and outperforming that are slim. Historically, almost no companies have delivered those levels of growth. Even Amazon, in the 2000s and the 2010s delivered terrific growth, but not at that level, yet the market's pricing that in. So for us to buy and own that as a Value investor, we would have to believe that that's going to occur. And in fact they could surprise, on the upside, deliver even more levels of growth.

PT - Page 18 (36:05)

And we've been there before in Canada. We've dealt with Nortel, Blackberry, Valeant, now Shopify. We may compare those businesses to two names that we've held for the long term, RBC and Toromont, which have both significantly outperformed the TSX. We have two businesses that have delivered steady growth but never growth that was expected to be exceptional or out-of-this-world high, and the others corrected.

We don't know if Shopify will correct the same way this time. We admire the business, we follow the business. If we were just to have our cake and eat it, we would hope that they continue to do well, but perhaps disappoint on the downside, indifferent to mediocre or negative stock price performance, giving us a better opportunity to enter and buy that name in the portfolio. Because we do want growth in the portfolio. Toromont and RBC, both have delivered very strong growth historically, and we have quite a good exposure to Technology in our portfolio with the exception of Shopify.

PT - Page 19 (37:15):

This slide over here, ultimately in a nutshell summarizes why the price of portfolio stocks on a P/E multiple basis is important. We went back historically and looked at 10 year returns for the US large cap market, the S&P 500. And we calculated what the return was over each decade, using rolling decades, and reflected that return back to what the starting price was of that portfolio. And you can see on the left hand side, there's lots of starting P/E multiples. The lower the starting multiple, the better the next 10-year-return was. Our Value portfolios are trading in the middle between 12 and 16x, which bodes well for forward looking returns over the next decade, something in the high single digit, if history repeats.

If we were to populate our portfolio with a bunch of growth stories, we would be very careful, and cautious, and wary because we would be putting ourselves in a situation where historically, at least, those multiples have often led to disappointing returns in the next decade. And the successful Growth managers who do that have to be very, very astute at not avoiding growth traps – companies that have delivered historically good growth, but ultimately disappoint relative to the expectations.

The price you pay does matter. As Warren Buffett mentioned, the term Value investing is redundant. It's all investing, and valuation matters. And we're really comfortable with evaluations in our portfolio, because they're exhibiting price levels that are much closer to the longer-term averages, and should deliver over the next decade. We hope returns that are much closer as well to long-term averages of returns for equity markets.

PT - Page 20 (39:14):

To wrap up before we get into some Q&A, cheap stocks are not necessarily a good value. Cheap stocks could be value traps. Cheap stocks are simply cheap. Value stocks are stocks where the price does not fully reflect the potential of the business. On the other hand, expensive stocks don't guarantee future growth. There's simply expensive. There's certainly future growth assumptions built into the price, but whether you get that future growth or not will ultimately depend on each business. And our skill certainly since our history in the early ’80s has been looking for those Value opportunities that are often less popular, but they do have good growth potential, and not following the crowded trade.

We are in a period here of quite a bit of uncertainty. We don't know for sure when we're going to emerge from the pandemic. We don't know when there'll be a vaccine, and what that return to work will look like, and what consumer behaviour will look like. Some industries will be more impacted than others. But what we do know is the Value trade. In other words, the popularity of the Value style.

Almost by definition, people are suggesting Value is dead. Popularity is low, and our portfolios are not part of the crowded trade. For the crowded trade right now, where's the money flowing? It's flowing into assets that produce higher returns than bonds, flooding into private assets, real estate, infrastructure, is falling into the indices, the ETFs, the S&P 500 which has a 20% weight in those FAANG stocks at higher valuation levels. So much momentum in that trade that it really just sets us up rather well. As Value managers, we're not part of the crowded trade.

The best time to own Microsoft is when it's trading at 9x earnings, even 12, 15x earnings, not when it's trading at 30x earnings. We would rather own businesses that have a very good chance as a whole of doing very well over the next decade, but there's less optimism baked into the price. In the time of uncertainty, we would rather own a portfolio with less optimism baked in. So let me stop there. Thank you for your attention and for attending. I'm going to stop sharing the screen here and take any questions as they come up.

Q&A

LM (41:55):

Thanks, Perry. We've had quite a few questions come in during your presentation. So, we might not get a chance to go over all of them, especially because we want to be mindful of everyone's time, and if we can let people out a little bit early today. But maybe if we can start off with some of the things that you were mentioning at the end of your presentation.

What do you think will be the catalyst for a change in leadership? What will cause Value to start outperforming?

PT (42:28):

Great question. Before I take that question, I just wanted to comment on one thing that I forgot to mention. There's a slide in the deck which shows the experience of equity portfolios of the various decades, and starting P/E multiples. If you look at the footnote on that slide, it looks like we've cut the data off at 2010. The reason for that is, every data point has to have a full decade because we're looking at the decade of experience after a particular starting point. The final starting point we could use, the final data point that we could use was the last decade to 2020, which began in 2010.

I just wanted to mention that because some people look at that chart and think that we've actually cut the data in 2010, and haven't looked at the last 10 years of stock returns, but we have. With that said, let's move on to probably the most common question frankly, that we're getting at client meetings is, “What is the catalyst?”

PT (43:26):

Let me start by saying that we're not particularly good at predicting where the markets are going in the next three months, six months, 12, 18, 24 months. And the word “catalyst” really requires you to speculate or comment on what that change is and when it might occur. The win is difficult for obvious reasons. I think the one obvious catalyst is we have stuck to our knitting. So what did we do during the pandemic?

We took a very hard look at all of that names on a bottom-up basis. We questioned whether those companies are in a state of disrepair, in a broken state, whether they will be able to survive the next 12 to 18 months. And as a result of those assessments, we eliminated some names from the portfolio. We did our homework there, but looked for companies that were beaten up to replace these with, but that would likely have a very strong chance of surviving over the next 18 months, buying companies that were also down 50, 60% or more.

And then we held onto our positions where we didn't have a problem. Simply there was a short term significant concern, but we felt that that concern would alleviate over time. Because we're still in those positions, our portfolio is extremely well geared to outperform when we eventually return to a more normal environment. This is not a normal environment. We're doing a joint presentation here in the office. We're separated. This is social distancing at its best. She's somewhere in the office. We haven't seen our clients for the longest time. We're all washing our hands when someone comes to the door. This is clearly a two or three-sigma event.

When that event turns, there will be a lot of optimism flowing to the stocks that got punished during the stay-at-home trade, and they will do much, much better, we believe, than the stay-at-home trade stocks. That's one catalyst. For me that's not sufficient. That all sounds good, but are there other catalysts?

By the way, we saw evidence of this catalyst in May. There was a time in May when I think it was too early, but the optimism came in. You didn't see it in your second quarter results, but the optimism came in, and sped into the equity markets. There was some relief here that the government had saved us with fiscal spending, and we would return to normal quicker. At one point, our US portfolio was ahead of the S&P 500 since the beginning of the second quarter by more than 10%. Now that optimism dissipated, and we moved down to a level where we were ahead of the market by a much more modest amount. But we have seen evidence of what I've just been describing.

PT (46:13):

The other catalyst which could happen is during a next wave of a market correction. This one is a little harder to call, but there has been even greater gap between Growth and Value put on the multiples of stocks in the last six months. It reached a very high level, and then it's being pushed out even further. It is possible with this much air in the balloon that if we had another ... I shouldn't say when. If we had another market correction, it's possible that the Technology stocks sell off more than the rest of the market, because there's so much optimism baked in.

If you think about businesses which as a group need to deliver 13% growth over the next decade per annum, in a world where the economy is probably only growing at three or four percent, that's a lofty growth advantage. Can that be sustained? At any point to sell off, you might get investors which have gone into the momentum trade with their Robinhood accounts on leverage, panic and flush out the names that they've bought. They haven't been buying Leith Wheeler Value names. That's another potential catalyst.

LM (47:32):

We talked a lot today about the U.S. market but I'm wondering if we can talk a little bit about the Canadian market here, and the concept of Value in Growth in Canada. Do you think that's a concept that we have here in Canada, where we have a much narrower market?

PT (47:53):

I think the Value/Growth divide in Canada is obviously a lot less pronounced. We know it's a lot less pronounced. They do attempt to split the Canadian market into Value and Growth indices. And when we've looked at the names that populate the Value one, and the names that populate the Growth one, you get some unusual results. Sometimes you get a big bank in the Value and a big bank in the Growth, and yet these two businesses really aren't that much different. It's less valid in Canada.

Of course, with Shopify, we now have a classic growth business, which is ultimately trading off very lofty valuation growth levels, and we get that from time to time. The Canadian market has narrowness. It has from time to time outside influence from energy, or from gold, or from some names like Shopify, or like Valeant, which enable us to take advantage.

But we've done well in Canada. If you look at rolling periods during most economic times, we didn't do quite as well in the first quarter compared to the markets, but the level of the miss was fairly modest. Now, interestingly enough, we're finding ourselves now in a period where we're quite different, but mainly because of Shopify and gold. So the market has enough peculiarities in it for us to be quite different, less because of following a Value style per se, more just from following businesses on a bottom-up basis and taking big weights in our favorite names.

LM (49:30):

We have quite a few questions here on different indices. I might just combine them all into one broader question. What is your view on passive investing? And more specifically: if an investor did look at passive, is it a Growth strategy, or is it more of a Value index investing strategy that they should be looking at in this type of market?

PT (50:04):

It's a good question. And the passive versus active topic probably is worthy of a webinar in and of itself. I would say that the interest in passive approaches typically occurs after a period where active managers have underperformed and passive approaches have done well. And usually that interest goes away when active managers prove their worth and deliver value. Unfortunately that's just human nature and the timing of it is that, you're typically selling active and buying passive when it's already had a successful run.

Now there are pockets of the market where it would seem that it's more difficult to add value, or you need to be very careful about the way you add value. The example I would give would be the fixed income market. I think in the fixed income space, you have to have very astute risk controls. You have to be very aware of the size of the bets that you take. You have to be very careful about making too big a bet in one or two areas, because the consequences of being wrong are very high when you're only making small amounts of value added for a time. If you lose a lot of value added on one trade, you might need a multiple series of other trades to make it back. Active bond managers need to be very careful.

But I think there's history would suggest that there's a group of managers who are good at making those risk assessments in sizing their bets, and adding value incrementally versus the bond market. Because when you buy a bond index, you're tied to the weight of corporate bonds and you're sort of a slave to that weight. So, for a manager who's astute at knowing when corporate bonds are more attractive and able to be nimble and move that sizing around a lot more, evidence would suggest you can add value.

The S&P 500 is really interesting. And it's probably the most interesting one of all, because we've had a decade where the S&P 500 has outperformed Value managers almost as an entire group. It looks like it's a top decile performer, but it’s end date sensitive to the last four years where Value has really struggled hard against the index. It's kind of a lay-up: how could a Value manager outperform the S&P, when the S&P has FAANG stocks running to 20% of that index?

But there was a 10-year decade during the 2000s when the S&P 500 really struggled against the same group of organic managers. We're dealing with the period which is one of low interest rates, low economic growth, high levels of share buybacks, high levels of lustre or popularity of anything showing earnings growth, the Growth companies. It stands to reason that they would have a successful decade against the index. That doesn't mean that it will repeat in the future.

PT (53:05):

But going back to your question of, "Should you consider an index?" I think it ultimately boils down to your level of comfort as an investor with performance patterns versus the index. If you're an individual investor who's dialed in, and I think we might have some individual investors who've dialed in, they might have a high level of patience and comfort with shorter-term performance versus the S&P 500 for our US portfolio.

And what I mean by that is that they don’t answer to any stakeholders – it's their own portfolio, it's their own money, and they might feel actually quite emboldened by the fact that we’ve underperformed and they might allocate more money to our portfolio during this period of time.

Our 20-year record: this is interesting. When I looked at it recently, this was early in the year, though, admittedly: our 20-year record versus the S&P 500, given the four-year struggle we've had as Value managers, was [still] neck and neck. We had obviously done really well versus the S&P 500 during some of the early years. We'd done pretty well during the first part of the 2000s decade. And then we'd given all of those gains back in the last four to five years. But the complete round trip versus indexing is actually a zero. As humans, we are certainly more influenced by what's happened recently. And by what happened in the 2002 to 2005 period, because that seems like ancient history and no longer the rules of the game.

PT – Page 24 (55:04):

Let me throw one other thing up though. Let me throw up something here from the presentation, real quick here. This one here is the Canadian index, the TSX versus Canadian Value managers, and it shows the five-year rank of the index versus that group of managers. A small number is a good thing, a big number is the bad thing. If you're a hundred, you're the worst manager in the peer group, if you're one, you're the best manager in the peer group. And lo and behold, right now, if you look on the far right hand side of your screen, it is a first quartile result.

The TSX because of Shopify is largely in the first quartile rank versus this group of Value managers. But if you were to have had the TSX in your portfolio for the last 20 years on a rolling five year basis, I would submit to you that you would have fired the TSX at some point along the way, because you would have had many, many prints in the fourth quartile. This group of managers has done a good job versus the index over the long term, despite Shopify today.

LM (56:08):

Just being mindful of time here. I might just try and wedge in one quick question at the end here, just on the low rate environment that we see ourselves in, our view on whether this will continue for the foreseeable future, and if that has an impact on this Value versus Growth gap.

PT (56:33):

I think the lower rates are already baked into the valuation differences between Value and Growth, and the belief that they will persist is already baked into those valuation differences. At the margin, low rates are typically not good for banks. Barrow Hanley has reduced our exposure to traditional banks in the US portfolio.

One of the risks going forward and I'll wrap up the answer in a moment is rising inflation. All of the spend on the fiscal side, and the question marks around whether this is sustainable, and what this might do to currencies could be inflationary in the long term, which you would think bring about higher rates. I don't think it's necessarily a given that low rates are here to stay.

LM (57:31):

Sorry, we didn't get a chance to touch on everyone's questions. As I mentioned, if we didn't get a chance to get to your question, please follow up with your portfolio manager, so we can make sure we can address it. But thank you everybody for listening in today.

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This presentation is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of presentation, but is subject to change without notice. Investment matters are complex and dependent on personal circumstances, please consult your professional advisor.