Traditional value investing in today's market: Q&A with Ty Nutt
In the following interview, Ty Nutt discusses his team’s approach to value investing and his perspective on the stock market including:
Q: Can you describe the team’s approach to value investing? Does your approach differ from other types of value-oriented approaches?
A: We take a traditional approach to value investing, meaning that we try to capitalize on discrepancies between our estimate of a stock’s intrinsic value and its price. Because we believe prices are influenced by human emotion and crowd psychology, we try to buy when we believe the market appears excessively pessimistic and sell when investors seem unduly optimistic.
I believe an important difference between our approach and that of deep-value investing is our use of the S&P 500® Index as our sector benchmark, and maintaining exposure to all 10 economic sectors. In our view, using the S&P 500 Index helps avoid some of the sector skews in the value benchmarks, and investing in all 10 economic sectors helps ensure broad diversification. Deep value strategies can potentially be absent from a sector entirely or have sector weightings several times that of the benchmark.
Another point of differentiation between us and some deep-value managers is that we’re focused on balance sheet quality. We look for companies that, in our view, have the financial strength to withstand an extended downturn. When we buy a stock, we feel that much of the risk is already discounted in the valuation before we make the purchase.
On the other side, relative-value managers may invest in “growthier,” less-discounted stocks that we might not be comfortable owning. We believe stocks trading at meaningful discounts help give us a kind of cushion — this is the difference between the stock price and our estimate of its intrinsic value. We believe such a discount helps protect on the downside and also presents a good opportunity for profit. Relative-value managers can also be more benchmark-centric. Some may establish position sizes based on the weight of individual names in the benchmark. We take a more active approach, establishing high-conviction positions of approximately 3% each, irrespective of benchmark weight.
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Q: Volatility is part of nearly every conversation about investing in today’s markets. Generally speaking, what is your team’s track record when it comes to volatility? How do you look to mitigate risk in volatile markets?
A: One of the strengths of this team is that we employ a process that was developed 35 years ago and has survived dislocations, including dramatic market corrections over the course of more than three decades.
To this end, there are two key elements in our approach that can help provide a measure of protection during down markets. Valuation is the more important of the two. We believe the greatest threat to a portfolio is permanent loss of capital. We seek companies that we believe are trading for much less than their intrinsic value over a 3-5 year time frame, and that appear to have less potential downside.
The other element is our bias toward what we view as higher-quality companies, those with characteristics such as:
- strong cash flows
- manageable debt levels
- diversified businesses
- good dividends
In our view, these represent some of the more favorable investment opportunities in the current environment because they may hold up comparatively well in down markets and may have the potential to produce competitive total returns in rising markets.
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Q: What are your thoughts on today’s economic and market environment? How does your view affect the way you’re positioned within your portfolios?
A: We're concerned about the current market and economic backdrop for several reasons, including:
- Over-indebtedness, which we think has contributed to sluggish economic growth, in the United States and abroad.
- A slowdown in corporate sales and earnings growth.
- The potential for a correction in record-level profit margins.
Perhaps most importantly from our point of view, market valuation levels are well above their long-run averages. For example, the price-to-earnings ratio for the S&P 500 Index (based on 5-year average earnings) was above 22 as of June 30, 2013 (Source: The Leuthold Group). This is significantly higher than its long-run average of 16 and puts the broad market in the highest valuation quintile relative to its own history.
Our view is that the stock market has been in a "secular bear" phase since March 2000. A defining element of a secular bear market, we believe, is P/E compression. Although we don’t expect valuations to move down in a straight line, we think they need to fall to much lower levels before a long-term “secular” bull market can begin once again.
With this in mind, we've maintained a fairly defensive positioning for some time. As previously noted, we're currently emphasizing quality and low valuation to help mitigate the risks posed by a down market. This is particularly relevant as we think we’ll have a corrective phase at some point in the next year or so.
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Q: On the other side, can you imagine any scenario under which the valuations push higher?
A: Sure. But how much farther the market can rise is anyone’s guess. Investors have been responding positively to the Federal Reserve’s ongoing stimulus — near-zero short-term interest rates and monthly purchases of Treasury and agency securities — and it appears these measures may continue for a while. Sentiment indexes have been elevated and there is evidence that retail investors are increasing their equity allocations.
Part of this may simply be the product of an environment in which equities appear to be “the only game in town.” Lately, some of the developed international alternatives have not been great, emerging market stocks have been weak, commodities have not held up well, and yields on many fixed income asset classes have been quite low. U.S. equities have gotten a lot of attention and have been receiving some positive flows. I think a continuing lack of competitiveness from other asset classes could move the market higher.
Under such a scenario, we would expect to trail the market simply because of the way we're positioned. Given our broader view of the markets — that we are in a secular bear phase even if cyclical trends move stocks higher — it is very important that we maintain a defensive character in our portfolio. We believe our approach has served investors well over the long term and seek to continue to do so in the coming years.
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The views expressed represent the Manager’s assessment of the market environment as of September 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s current views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Investors should not place undue reliance on forward-looking statements as a prediction of actual results. In addition, we disclaim any obligations to update any forward-looking statements to reflect events or circumstances that occur after the date of this document.
Value investing focuses on buying stocks that are trading at bargain prices based on fundamental analysis, then holding them until they become fully valued. Typically, value investors select securities with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.
Intrinsic value is the actual value of a company based on an underlying perception of its true value that includes aspects of the business. This value may or may not be the same as its current market value.
The P/E ratio is a valuation ratio of a company’s current share price compared to its earnings per share.
Diversification may not protect against market risk.
There is no guarantee that dividend-paying stocks will continue to pay dividends.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.