Unlike the growth stock manager—who, in theory, buys and holds—the mandate of the value manager is to “buy low and sell high.” Add positions to the portfolio when they are trading well below intrinsic value, thus offering a compelling margin of safety and an outsized future expected return. Sell them when the opposite is true.

To illustrate the return potential of this strategy, consider one choice available to investors in 2006. Perennially cyclical John Deere was selling at 14 times trough earnings. Amazon, the marquis e-commerce growth darling, sold at 56 times rising earnings. Its multiple shows the extreme expectations investors believed its future held. Deere’s PE told the opposite story. For the value manager, however, the choice was clear. John Deere was a deal.

Examine the Amazon and John Deere charts below. The daily high-low-close stock price (white) over trailing 12-month earnings per share (green) determines the price-to-earnings ratios above. Ben Graham said “the market is a voting booth in the short run and a weighing machine in the long.” Accordingly, the best fit price trend line (fuchsia) will, for our illustrative purposes, serve as a crude proxy for intrinsic value.


(Click chart to enlarge)

If a growth investor who purchased Amazon on June 16, 2006 held it until June 16, 2017, the investment would have returned 27.3 times initial capital. By contrast, the value manager who purchased John Deere at its lows in 2006, 2009, & 2016 and sold the positions at the peaks of the subsequent rallies, would have earned 20 times the initial stake, pretax. These examples are intentionally and preposterously best case. The reader can adjust the results as appropriate for individual circumstances.

What is absurd, however, is that few could have envisioned the utter dominance Amazon was to have across retail and data service sectors, not to mention its popularity in the capital markets. While it was clear that the internet would revolutionize much of the retail world, in 2006 Amazon was still best known for books, not apparel, electronics, entertainment, cloud storage, or web hosting. The evolution of its offerings was hardly predictable. Eleven years later, it is now selling for 186 times earnings.

Conversely, even a novice investor could have rightfully concluded in 2006 that stodgy John Deere was a zebra whose stripes would not change. Its fortunes are tethered to cyclical markets. Deere is an example of mediocrity by association. It is the combination of its prosaic business and mean reversion that makes the John Deere’s of the world so appealing to the value investor.

Let’s pause for a minute and put the tale of these two companies in perspective. In my last post, I applauded the 19.1% compounded pretax annual return of Warren Buffett since 1965 as the gold standard. That’s over three times the growth rate of nominal S&P earnings. For those interested, the returns for Amazon and Deere in the constructions above are 35.5% and 31.9%, respectively. They both outpace Buffett, a highly improbable feat. Buying and selling at price extremes with Deere, or holding despite stratospheric valuations with Amazon, would challenge the mettle of any investor. More realistic trading behavior would mean significantly lower returns. But even with some serious haircuts, it is clear that staid and predictably cyclical companies offer a potential for outstanding returns. Since it is rare to successfully identify the next MVP still in high school, cyclicality also avoids the risk of choosing wrong.

For the one-in-a-million investor who committed 5% of his capital to the e-commerce wunderkind in 2006, the position, if left untouched, would now represent 40% of his portfolio assuming his other holdings grew at a 10% rate. Chances are the Amazon position would have been regularly pared back in the name of diversification, and thus its contribution to the portfolio’s return would be reduced accordingly. Not so with Deere, or the host of other companies that behave similarly. This is a choice between the tortoise and the hare—Deere with its slow nonlinear growth and Amazon with its blistering corporate performance.

With so many cyclical companies available, one need not take the long shot odds of choosing a hare. Our above investor was long Deere only 43% of the time, waiting in cash or finding other mispriced cyclicals in the interim. A skilled manager can achieve hare-like returns from tortoise-like companies, especially given he could have sequentially owned more than one during the period discussed. Theoretically, this seems to me a much more achievable strategy today than identifying the next runaway Amazon opportunity. But this simple idea is most difficult in its execution. The next post will explain why.

If you want to see how one rather remarkable investor seizes the opportunities that established small- and mid-cap cyclical companies offer, take a close look at Eric Cinnamond’s blog. I’ve known and respected Eric for a long time and you won’t be disappointed.

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