The mundane proves its worth
Value players should cast their net wider than cyclicals and go for ‘toll takers and gate keepers’, advises Chris Bertelsen of Phoenix
Reality is that most US value managers, especially small-cap value managers have underperformed their growth counterparts over the past 18 months. Those value managers that describe themselves as “new age” value managers have had an easier time. Practitioners of “truth in labelling” should blush to hear the convoluted justifications by “new age” value managers for purchasing Microsoft under the guise that it is the cheapest way to play the internet; or America Online because it is a “dot.com” that has earnings.
The migration of traditional value managers to “new value” is caused more by career risk and peer ranking pressure than by opportunity. Managers are afraid that if they do not keep up with their peers, they won’t be paid (or, worse, will lose their jobs). Ranking pressure (star systems, quartiles, etc.) has also taken its toll on value managers. I have often heard the question, “How can I receive a favourable rating if my whole style is doing so poorly?”
Surprisingly, migrating to growth (some use the word cheating) is not the answer. There is a popular misconception, a myth that is being perpetuated by the ignorant that the only merchandise value managers should buy is junky cyclical and consolidating commodity companies.
What sense does it make to buy US industrial cyclical companies at the end of a nine-year period of expansion, when pricing power is limited and deflationary forces are still pre-eminent worldwide?
If you wanted cyclical exposure, how much more sensible to buy those out-of-favour, low expectation, economies such as Korea, Taiwan, Singapore or Hong Kong at the start of 1999, rather than try to pick winners from the increasingly lean pantry of US cyclicals such as BF Goodrich, Johnson Controls, Ingersoll Rand, United Technologies, Ford, Goodyear Tire, Kaufman & Broad, Phelps Dodge etc. In the US, the winners in this traditional “value” area, such as Aluminum Company of America, Union Carbide and Honeywell, are scarce.
So what is the poor value manager to do? Start by embracing both the quantitative data and the fundamental facts without any preconceived conclusions or biases. A study of the foremost value practitioners – Ben Graham, David Dreman and John Neff – emphasises discipline, opportunity and concentration. Historical analysis will show that these managers did not force themselves only to buy low-growth or no-growth “value” companies, or to focus on second-tier players, or ignore the fundamental story. The surprise is how much profit the 1990s held for the value managers who were willing to concentrate on quality opportunity when almost all statistical measures were attractive.
Truly the financials in 1991, the autos in 1992, the drug companies in 1993, were great opportunities for value managers. What we quickly forget is that software companies in 1994, hardware, chip and computer stocks in 1995 (remember when the Intel Pentium chip couldn’t divide), and retail stocks in 1996 (even Wal-Mart was a low P/E value stock), as well as the banking stocks in 1997, also provided splendid opportunities.
As recently as a year ago many technology stocks were at clearing prices. Growth and momentum managers were sellers, but value characteristics such as financial strength, low P/Es (both current and forecast), and low price to sales ratios, were at 10-year lows. If you bought them, you have been richly rewarded as a value manager. If you feel that these stocks were not “traditional” value, look at what levels Dallas Semiconductor, Amkor Technologies, C-Cube, Smart Modular Devices, Atmel, just to name a few, were selling at last October and November. Who wanted Motorola last year? Who wanted Ericsson this year? Does anyone want to buy Quantum DSS at 11.4 times fiscal year-end March 2000 earnings? Or Oak Industries at 20 times current earnings?
The market makes something cheap everyday not just technology. Only last week, a traditional value manager could feed at the “Tyco International” trough as the momentum crowd turned a pricey growth stock into a great value play.
The new economy is full of “value plays” both in the US and in Europe. As value managers we are delighted not to be in the “dot.com” crazy area, indeed we feel that by buying the low P/E ditch diggers (eg Mastec, Dycom, Quantum Business Services) or the boring plays on broadband (eg First Data, Corning); we can be as successful as those who own Cisco, Lucent and EMC Corporation without paying steep premiums to the market.
Another part of our view of millennium opportunities for value managers in the “new” economy is in two areas. We call them toll takers and gatekeepers.
While what travels over the information superhighway may be glamorous, it is the tollbooth at the beginning (or end) of this highway that should interest value managers. The toll takers are:
q Not as sensitive to technological obsolescence.
q In easy-to-understand businesses.
q Not highly leveraged.
q Have positive cash flow.
q Show growing profits.
Who are they? Large-cap stocks like AT&T, Alcatel, GTE, Diebold, Federal Express and Pitney Bowes or small-cap stocks, such as Valassis, Crown Castle, Black Box and Radian Group. A large-cap toll taker, such as Federal Express, at 20 times current earnings (a 25% discount to the S&P’s P/E 500), has a growth rate of over 15% and collects the toll on both business-to-business and business-to-consumer e-commerce.
Valassis, a small-cap toll taker, trades at 19 times current earnings and not only caters to coupon-clipping Americans with its free- standing Sunday paper inserts but also is prepared to offer the same advantage to the new wave of e-shoppers.
The gatekeepers represent a similar opportunity for value players. The gatekeepers have the following characteristics:
q Proprietary technology, reasonably valued and generally misunderstood by Wall Street.
q Dominant market presence (but not necessarily dominant market share).
q Necessary component of the new economy (tied to future growth of world productivity).
q Expanding margins over the next 12 months.
Representative large-cap gatekeepers would be Fairchild Semiconductor at 22 times next year’s earnings, Watson Pharmaceuticals at 17 times next year’s earnings and Allied Signal at 18 times next year’s earnings. Representative small-cap gatekeepers would be Cooper Companies at seven times next year’s earnings, Dallas Semiconductor at 21 times next year’s earnings or Gilat Satellite at 18 times next year’s earnings.
Growth strategies that have worked splendidly over the past 18 months often involve paying full price for ownership in the new economy companies. Value managers can be just as successful by owning the more mundane toll-takers and gate-keepers cheaply. They need not contribute to the myth that value managers have to be overweighted in questionable cyclical plays.
Chris Bertlesen is portfolio manager and director, value team, at Phoenix Investment Partners