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  • Glenn D. Surowiec

Take Notice: Three Trends Value Investors Should Watch Now

I always tell my clients: 90% of the financial advice out there is bad. Just plain bad. My job is to find the 10% – the relevant, the useful, the informed – and get it into the hands of my clients. Here are the three trends and revelations making their way into my 10% this month, which can and almost certainly will impact value investors like us.

1. Avoid the value traps.

At GDS Investments, I actively research companies and industry verticals undergoing significant upheaval. My takeaway is this – avoid the disruptees, and invest in the disruptors. One vertical that stands out today for its pace of change is retail. Excerpted, here's how the WSJ reported it on April 21 of this year:

American retailers are closing stores at a record pace this year as they feel the falloutfrom decades of overbuilding and the rise of online shopping.

Just this past week, women’s apparel chain Bebe Stores Inc. said it would close its remaining 170 shops and sell only online, while teen retailer Rue21 Inc. announced plans to close about 400 of its 1,100 locations.

“There is no reason to believe that this will abate at any point in the foreseeable future,” said Mark Cohen, the director of retail studies for Columbia Business School and a former executive at Sears Canada Inc. and other department stores.

Through April 6, closings have been announced for 2,880 retail locations this year, including hundreds of locations being shut by national chains such as Payless ShoeSourceInc. and RadioShack Corp. That is more than twice as many closings as announced during the same period last year, according to Credit Suisse.

Based on the pace so far, the brokerage estimates retailers will close more than 8,600 locations this year, which would eclipse the number of closings during the 2008 recession.

At least 10 retailers, including apparel seller Limited Stores Co., electronics chain Hhgregg Inc. and sporting-goods chain Gander Mountain Co., have filed for bankruptcy protection so far this year. That compares with nine retailers that declared bankruptcy, with at least $50 million in liabilities, for all of 2016.

Unfortunately, what I know as a value investor is that legacy companies are trying to “outswim a tsunami.” It won’t work, regardless of how quickly they close stores. Through disciplined research and by following companies for years, I know that today’s store closings are a late reaction to yesterday’s problems, and fail to properly address the structural inefficiencies of an old operating model (asset intense) in a world that is quickly moving toward an asset “light” distribution model. This trend will ultimately affect every brick-and-mortar retailer. As I comb through the carnage in this sector, I’m finding very few opportunities and lots of value “traps” that look cheap on the surface, but upon closer inspection, are actually saddled with an obsolete business model.

2. Value is ready to outperform.

As it always does after a lengthy period of underperformance, value will significantly outperform growth over the next cycle. The Journal gave us a nod this week when it wrote about value investors as "a choosy lot" (why, thank you), whose patience will admittedly be tested:

Value stocks, those that are cheaper than many peers relative to earnings or reported net worth and are typically purchased by fund managers anticipating long-term appreciation, have significantly lagged behind their growth stock counterparts this year, compounding a gap that has persisted since the end of the financial crisis.

Instead, investors have gravitated toward companies with fast earnings or price growth, such as Inc., Netflix Inc. and Tesla Inc., and the market’s price-earnings ratio has continued to rise—a trend that many value investors contend cannot continue forever.

Stocks that look cheap relative to traditional fundamental metrics such as profit or cash flow have fallen so far out of favor that Goldman Sachs in June questioned whether the markets are witnessing the death of value investing. With value investments in Europe and Asia also struggling, value funds globally are on track to post their worst performance this year relative to growth funds since before the financial crisis.

The struggle for value stocks over such a prolonged period contradicts the popular investment approach coined by financial analyst Benjamin Graham, known as the father of value investing, and since popularized by Warren Buffett. The billionaire investor and Berkshire Hathaway Inc. chairman has attracted a legion of followers who remain confident that value investing will never go out of style.

From the Great Depression to the U.S. tech bubble to the global financial crisis, the notion that a new paradigm would replace value investing has repeatedly occurred. Those predictions have almost always ended poorly.

While value investing appears to have lost some luster now as the so-called FAANG stocks— Facebook Inc., Amazon, Apple Inc., Netflix and Google parent Alphabet Inc. —have surged in value, the most steadfast devotees to value-style investing are often the ones that benefit most in market downturns.

The market’s attraction to highflying stocks punished value investors in a similar fashion in the late 1990s during the dot-com bubble. Growth stocks beat their value peers toward the end of two major bull markets that peaked in 2000 and 2007, before large market selloffs reversed the trend, putting value stocks ahead.

It continues to be important for investors to prepare today for what’s inevitably coming tomorrow. GDS Investments does exactly that – helps clients see around the corner as important market inflection points take hold.

3. As it turns out, potential wears heels.

Several years ago at a Women’s summit, Warren Buffett observed: “What makes me even more enthusiastic about the future, is that 90% of that time [in the past] we were only using half of our talent. Think about what would happen if we used all the talent for 100% of the time,” he said. “It’s like having one hand behind your back.“

Never did this quote come to mind more than last week when this remarkable piece hit the Journal:

Women now run 27 of the S&P 500 companies—or 5.4% of the total, reports Catalyst, a research group.

Similarly, 32 women led Fortune 500 companies as of early June. That equaled 6.4%, the highest proportion in the 63-year history of the Fortune 500 list. The figure soon slipped to 6.2% after Marissa Mayer relinquished the helm of Yahoo Inc.

Those figures, along with reports showing only minor gains in women’s representation in corporate boardrooms, suggested that gender parity in corporate life is at a virtual standstill, despite companies’ ever more vocal commitments to diversity.

So intractable does the issue seem that one in four Americans believes they are more likely to see time travel during their lifetime than they are to see women running half of Fortune 500 firms, according to a 2017 survey conducted for the Rockefeller Foundation. Read more >

I think this is an important topic to take a stand on. It is utterly ridiculous that the S&P 500 has only 27 women CEOs. First, the foundational skills necessary for the position are clearly not gender-specific: honesty, integrity, leadership, intellect, and so on. Second, Corporate America is severely limiting its potential if half the population is excluded from top jobs. To channel Buffett, imagine what would happen if we opened up senior positions to the entire population.

Glenn D. Surowiec
Registered Investment Advisor
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