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Issue XX

July 1999

Sharp Investing

Value Investing: Dinosaur or Slumbering Giant?

In 1998 value investing was crushed by growth investing. In fact, over the past several years value investing has failed to live up to its long-term track record, prompting the usual arguments at this stage of the cycle that traditional value investing techniques are outdated, dead, and irrelevant in today's rapidly changing world. Many value investors are throwing in the towel, and many "value" mutual funds have capitulated and have taken large positions in companies like and AOL, somehow justifying their 500+ price/earnings ratios as a value investment. The conventional wisdom is that the only way to make money in today's markets is to hold your nose and buy what's hot, regardless of how ridiculously it may be priced.

Could this be true? Is it possible that the only way to make money in the markets for the foreseeable future is for all investors to pile money into a select group of fifty companies assuming that they can do no wrong and are a continuous bargain at any price? Is it true that if you are not a "dot-com" company that your business is doomed to fall further and further behind in the economic pecking order?

Traditional measures of value may no longer be valid in today's new world.
This argument has some validity. For example, conventional investing wisdom up until recently was that if the dividend yield on the S&P 500 went under 3%, the market was overvalued. Well, the yield has been under 3% for over five years now, is approaching 1%, and this measure of value seems no longer relevant. Another measure under pressure is book value, which is a yardstick measuring the accounting value of a company. In today's economy, many high growth companies are much more knowledge-based than capital-based, which makes their book value a much less valid measure of stock value. As a result, the price/book value of the S&P 500 is over six, compared to its long term average of about two.

I am not nearly as convinced that ratios such as price/earnings, price/sales and
price/cash flow need any adjusting for today's economy. I don't see any evidence that a good business no longer needs to generate certain levels of earnings, sales and cash flow in relationship to it's price to be an attractive investment. Regardless of the micro-measurements an investor uses to classify value, on a macro level I find it very difficult to think of many examples of a value investment worth paying more for than the average market premium.

Real Estate & Financial Fair, July 20, 7:00 - 9:00 PM

Local Professionals Answer Real Estate & Financial Questions at Free Fair
Sharp Investments will be joined by a dozen other local professionals at the Lincoln Center Building, 10220 SW Greenburg Road, Portland on Tuesday evening, July 20th to provide free advice on everything from mortgages and home buying or remodelling, to taxes, investments and wills. Also covered will be title and escrow, insurance, interior design, landscaping and painting. For reservations and further information, contact Lisa Fredinburg 977-3685 or Chad Fast 644-0611. RSVP by July 14th.

But this is my main point: The yardsticks used to measure value may change over time, but the human nature that creates the value opportunities will always exist.

Can anyone dispute that humans dislike uncertainty? Value investing is living with uncertainty. There are two types of value
stocks, economically sensitive (cyclicals) and fallen angels (busted growth stocks), which both provide uncertain earnings. Economically sensitive companies (energy, commodities, financials, real estate, transports, manufacturing, construction, etc.) provide uncertain earnings because their fortunes are tied to unpredictable economic conditions. The more uncertain economic conditions, the more investors avoid these companies - to the point that the worst-case scenerio becomes built into the stock price and you have an attractive value opportunity that pays off when economic conditions inevitably improve. The "value is dead" crowd doesn't invest in economically sensitive companies because they think they are dinosaurs in today's economy. Will the internet lessen the demand for oil, real estate, home building, automobiles, etc., on a worldwide basis? These companies may not have the growth prospects or the earnings certainty of market darlings, but at certain points in the economic cycle they will become value opportunities for those investors willing to shoulder the uncertainty for the eventual return of conditions that favor the cyclicals.

Fallen angels are former high growth companies that have run into problems: financial, legal, competitive, or industry wide. Many are companies that once traded at market premiums, grew fast and furious for a number of years, but eventually the high growth causes problems that interrupt the steady output of increasing earnings. Once these companies let down investors for the first time, the market casts them aside (usually for a year or two) until they provide several quarters of proof that they are back on track again. They then go through another cycle of boom and bust. During the bust phase, investors avoid these companies like the plague because of the uncertainty of when the next boom phase will come. Once the uncertainty is removed, the stock price quickly reflects renewed investor interest.

Is value investing dead? When people no longer avoid uncertainty, then it can be said, with certainty, that value investing is indeed dead. But until that happens, value investing will continue to outperform over long periods of time due to basic realities of the human psyche.

OK, if value isn't dead - when is it going to wake up?

Fall Presentation, October 1999: Creating Wealth through Value Investing. More information to follow or contact us at 520-5000.

As you can see from the chart on this page, value hasn't significantly outperformed growth since 1993. This dormancy is not unprecedented, but seems like an eternity to value investors that saw their portfolios stagnate in 1998 while growth stocks roared ahead. Taking a look at the chart shows just how rare 1998 was. Three times in the last 35 years growth has outperformed value by over 20%. However, eight times in the past 35 years value has outperformed growth by over 20% and three times by over 30%. What this shows is that, although in some years growth investing wins big, in most years it is value investing that provides the greater reward. In fact, over the 35-year period shown, value investing averaged 8% higher annual returns than growth investing. The key is to realize that value investing does provide higher returns, but not every year, or even the occasional two or three year period. In fact, there has not been a ten-year period anytime in the last 100 years anywhere in the world where growth investing has

outperformed value. If you've got ten years, you can be very confident that a value approach will not let you down.

While trying to predict the unpredictable shift from growth investing to value investing is like trying to predict next month's weather, there are some positive signs of a shift in investor preferences from growth to value coming in the near future:

  • Higher interest rates tend to hurt high- growth, high-valuation companies more than value-priced companies, so as interest rates climb, holding high-priced growth stocks becomes less attractive.

  • Strengthening commodity prices are a sign of an upswing for economically sensitive companies. Energy, real estate, paper, steel and other basic industries have all picked up considerably over the past three months.

  • Latin America and Asia are starting to show signs of strength and recovery from their long recessions, which is an indication that the global recession that has gone on since 1997 is on the path to recovery.

  • Several false starts of outperformance by smallcap stocks and value stocks over the past six months show that investors are just waiting for an excuse to move money from one style of investing to the next.

Need a speaker? If you are a member of a professional or trade association or community organization that is looking for qualified speakers, consider Sharp Investments portfolio managers. We feature several highly professional and educational talks on a variety of investment-related topics ranging from retirement planning to choosing a financial professional. Presentations can be tailored for any group and for time limits from twenty minutes to two hours. Topics currently available are listed on our website at under Seminar Information. Presentations may apply to continuing education credits.

While traditional measures of value stocks will continue to evolve over time, the basic fact remains that buying companies at a discount to the market is not a strategy that has gone the way of the dinosaur.
Value is not dead, but merely slumbering in one of its regular periods of dormancy.

Sharp Investments
13160 SW Butner Road
Beaverton, OR 97005

I'm sure for those of us that plan on investing for the next 30 years, another similar situation will arise, just as it did in 1969 and 1990 when the "value is dead" crowd got a lot of attention only to be proved wrong yet again. Just as I am sure that over the next 10, 20 and 30 years value will continue to outperform growth by about eight percent per year.

No one knows with certainty when the party for growth stocks will end. Value stocks will never outperform growth stocks each and every year. What is known, with scientific evidence, is that investors with at least a ten-year time horizon should be in value stocks, which have never failed to outperform over this period of time. A ten-year race is a long time. It makes little sense to panic if you happen to get behind in the first year or two of a ten-year race, especially considering that in almost all ten-year periods value falls behind growth at some point - but has never failed to cross the finish line first.

Next Issue: Y2K -
Prepare or Panic?

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