FOOL ON THE HILL
An Investment Opinion
Value Doesn't Work... Really? Warren Gump (TMF Gump)
January 4, 2000
Anyone who has been tracking the market over the past year knows that value investing is passe. Investors no longer need to consider the valuation of companies in which they're investing. Business models, realistic profitability potential, and competitive risks are all concerns of the Old World. In the new paradigm, all investors need to do is find the next "big" technology, put down their money, and let it ride. (A hint for those not familiar with my writing: think sarcasm.)
Having heard and read about the disastrous performance of value stocks, I was pleasantly surprised when scrolling through my preliminary 1999 investment returns. Even though I am primarily a value investor, my overall returns should end up exceeding the 21% total return of the S&P 500. How could this be? Well, it certainly wasn't from the value stocks I put my money into last year. As demonstrated by the negative performance of the hypothetical online value portfolio I started in May, these stocks stank. What saved me were investments made over the prior two years.
One of the biggest boosts to my portfolio came in biotechnology. You might not think biotechs are a value-oriented sector of the market (using today's valuations and traditional metrics, they certainly are not). Nonetheless, you could have found some interesting situations a couple of years ago. At that time, industry leader Amgen (Nasdaq: AMGN) was suffering from changes in governmental reimbursements for its leading drug, Epogen. This slowed down the company's earnings growth to about 3% for a couple of quarters. In addition, professionals were bemoaning the company's weak research pipeline. The stock had fallen about 30% from its prior year high and was trading for about 20x earnings estimates.
I didn't really know what was going to happen with biotech companies, but it seemed like there could be some exciting developments. With an opportunity to invest at what seemed like an attractive valuation, I took a baby step into the business by buying a few shares. Within a few months of this purchase, the government favorably altered its Epogen reimbursements policies. A few interesting developments also started to emerge from the company's pipeline. Not surprisingly, the stock started to move up. As more encouraging news has emerged over the past year and earnings growth accelerated, the stock continued to increase. Last year, Amgen was up 130%.
I become more enamored with the biotechnology sector as I learned more about Amgen and what was going on in the industry. It seemed like quite a bit of this activity was happening at smaller companies. Knowing that I lacked the medical background to really understand what they were doing, I looked for an indirect way to invest in these companies.
In that search, I stumbled across H&Q Life Sciences Fund (NYSE: HQL), a closed-end fund with an emphasis on investing in smaller biotech companies. At the time, the fund was trading at a 15%-20% discount to the value of its underlying portfolio. I decided to put a little money there. The first partial-year returns were not encouraging: The market value fell about 15% over my first seven months of ownership. Last year was a different story as the fund returned over 80% and contributed significantly to my overall returns.
International investing was a bugaboo for investors in 1997 and 1998. I knew that Asian, European, and countries with emerging markets faced some serious problems, but I couldn't imagine that there weren't going to be investment opportunities. I started dollar cost averaging in some international index funds in 1997. The initial returns weren't too impressive: The Vanguard Emerging Markets Index Fund (VEIEX) fell 16% in 1997 and another 18% in 1998; the Vanguard Pacific Market Index Fund (VPACX) was down 25% and up 2% during the same time periods. Putting that in perspective, the S&P 500 returned more than 20% each of those years.
After the international meltdown during the fall of 1998, I scooped up shares above and beyond my regular quarterly investments. It simply seemed like the pummeling endured by those markets was far too excessive. As of today, that decision to buy looks pretty good: The Emerging Markets fund was up 61% last year and the Pacific Fund increased 57%.
Did I mention Nortel Networks (NYSE: NT)? In October 1998, the company was trading at around $17, less than 20x trailing earnings. I decided to pick up a few shares at that seemingly attractive price when everyone else thought the company was doomed. By the end of that year the stock had increased to around $25. Yesterday, the stock closed at over $100. (I happened to sell that one a little too early, but still achieved a very satisfactory gain.)
My portfolio also benefited from holdings in the "fun money" category, which usually represents 5%-15% of my portfolio. These companies are ones that are fun and exciting to invest in, but their underlying business fundamentals (and ability to exceed investors' rosy expectations) are more questionable. For the past several years, this part of my portfolio posted negative returns. Last year, however, it experienced a dramatic turnabout as a couple of Internet and genomic companies led to total returns in excess of 300%.
Adding last year's experience to my knowledge base, I haven't significantly altered my investing strategy. Putting money in companies that look reasonably priced relative to their long-term prospects should yield solid gains. If I want industry leaders to be part of my portfolio, I'll have to exhibit patience and acquire them when they are out of favor for some reason (right now, a lot of my time is spent looking at food makers, restaurant companies, and beaten-down American companies with significant international exposure). Satisfactory returns from such investments may not occur immediately, but the value inherent in good companies rarely goes unrecognized forever.
If there has been any shift in my strategy, it has been an increased willingness to hold onto compelling companies when their prices soar. A couple of years ago, I probably would have sold most, if not all, of my Amgen stake when its P/E surged above 40. I'm a little more reluctant to do so now, since I strongly believe in the long-term prospects of the biotech industry and Amgen's ability to participate in them. Holding onto companies in these situations has several advantages, such as allowing me to stay invested in great companies, enabling me to defer paying taxes until I ultimately sell, and adding portfolio diversification that increases the likelihood of my achieving satisfactory returns. This change doesn't mean that I'll hold all good companies through any price, but it does mean I'll be a little less trigger happy to sell and lose out on future appreciation (and loss) potential.
I don't know when the small- and mid-cap stocks that make up the majority of my portfolio will start to achieve attractive returns. It would be nice if it happens sooner rather than later, but that may not occur. I am confident, however, that these companies will ultimately achieve solid long-term returns if their underlying business fundamentals (earnings, profitability, and cash flow) continue improving.
The real value of any stock is the discounted cash flow that the company can generate. Keeping that in mind, figuring out a way to roughly estimate companies' long-term prospects and developing enough confidence in one's own analysis to contradict Wall Street's myopic minds are all traits of investment legends.