Why Value Works. The Case for Investing in Undervalued Stocks

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1 Why Value Works The Case for Investing in Undervalued Stocks For many decades, the value style has been one of the most successful ways to invest in equities, delivering handsome premiums to broader equity indices across regions (see Display below). But in 2008, value investing experienced one of its worst periods ever and our portfolios underperformed. While a rebound has begun in 2009, investors may wonder whether their losses can be recovered by staying true to the value approach. In our view, a closer look at the basis of investing in stocks that are cheaper than the market when measured by price-to-book value, earnings, cash flow or revenues, suggests that value investing is likely to work as well in the future as it has in the past. How Are Value Opportunities Created? Although the value approach to investing was first set out by Benjamin Graham over 70 years ago, the evidence to explain why it works has accumulated more recently. Empirical studies in experimental psychology since the 1960s have identified several biases that explain how emotions can lead investors astray. Two of these are particularly relevant in value investing loss aversion and anchoring. (continued) SUMMARY Value investing is being challenged afteraterribleyear.butinourview, the fundamentals of value investing have not been undermined by the cyclical downturn. As markets recover from the trauma of 2008, we believe that using in-depth research to exploit the enduring emotional biases on equity markets will vindicate value strategies and deliver solid outperformance in the long term. Value Investing Works Appreciation of 1 Local Currency Unit Invested in Value Index vs. Broad Index, US Dollars MSCI World MSCI World Value MSCI Europe Value MSCI Europe MSCI US Value MSCI US MSCI Japan Value MSCI Japan US$47 US$ MSCI World Value MSCI World US$28 US$4 As of July 1, 2009 Source: FactSet, MSCI and Bernstein SEPTEMBER 2009

2 max char (continued from cover) Almost all companies occasionally Display 1 encounter some kind of issue which causes concern about their earnings. Perhaps they need to invest more in new product development in reaction to a competitor s innovation, or they may be facing a short-term cyclical fall in demand. As a result, their share prices lag the market. Loss aversion means that investors often overreact to such bad news, even if there is clear evidence that its impact is likely to be short term. Investors then often become anchored to a negative view and ignore evidence of underlying strengths in a company s position. Emotional Biases Lead to Mispriced Stocks Investment Controversy Profits & Stock Price Decline Research Conclusion Which? Long-Term Earnings Power In short, value investing works because stock markets are not perfectly efficient. Since investors can be emotional and subject to psychological biases, some stocks become mispriced when an investment controversy triggers a decline in value of a stock or group of stocks (Display 1). Of course, sometimes share price falls are justified, reflecting a fundamental, perhaps permanent, deterioration in industry conditions or a company s competitive position. But often, depressed or inflated company earnings revert to the mean in their industry. The pressures of competitive markets reduce outsized profits, while underperforming companies improve performance by adopting innovations produced elsewhere, removing weak management, cutting costs and a variety of other measures. But this doesn t always happen. So the value investor s key task is to distinguish chronic underperformers with ongoing or intensifying share price weakness from companies where time and management attention are likely to improve performance and prompt a recovery in the share prices. What Is a Value Stock? Value investors often buy good companies that are temporarily undervalued. But weak companies in unattractive industries can also be attractive investments if share prices fail to fully reflect the cash flows that the company will produce, even if these are declining over time. Some common controversies that create value opportunities include restructuring, cyclical declines in earnings and changing industry dynamics: Source: AllianceBernstein n Restructuring Share price is depressed as management undertakes necessary restructuring to restore margins n Cyclical declines in earnings Market overreacts to a temporary fall in earnings caused by the product, industry or economic cycle n Changing industry dynamics Investors are excessively pessimistic about the impact on returns of worsening industry dynamics, e.g. driven by technological or regulatory change Not surprisingly, the market turbulence associated with the financial crisis of 2007/2008 created many value opportunities in all of these categories. In some cases, all three themes were present in a single opportunity. Financial stocks, for example, remain at the eye of the storm. Many finance companies are restructuring their operations Pie Labels as major institutions have been absorbed by their rivals. Earnings 10% in several areas of banking are Bar Labe undergoing severe cyclical decline. And industry dynamics are in a state of flux, as regulatory regimes are changing rapidly in borders for pies many jurisdictions. AND As stacked ever, bars we use deep fundamental research Series 1 Series 2 to identify those banks and 0.75pt insurers that are undervalued today, but are capable of surviving the slump and generating longterm outperformance. Pie Labels Bar break 10% Value opportunities also emerged in areas well removed from the heart of the financial crisis. Take pharmaceuticals, for example. Share prices of many drugmakers have suffered because an imminent wave of patent expiries across the industry is expected to increase competition from generics, 2 Why Value Works 1 dig 2 dig dig 4 dig

3 l t width incl labels axis label start eroding revenues and profitability a classic change in industry dynamics. Yet some companies have relatively strong drug pipelines, which will help them maintain growth as they lose revenue from patent expiries. Others are restructuring by cutting costs to maintain earnings. In many cases, pharmaceutical companies continue to offer robust and stable cash flows at very attractive valuations. Of course, in any sector, it is difficult to consistently distinguish winners from losers, particularly when anxiety is elevated as it was last year. Like any investment research, it involves making predictions about a highly uncertain future. In fact, over time, our winning percentage is not dramatic. But even a relatively modest success rate can translate into substantial outperformance because the winners tend to win by more than the losers lose: some stocks may increase in value by several hundred percent, while only very few ever decrease by anything 17% close 100% to the maximum possible 100%. 21% 16% The key to maintaining 7% a solid winning percentage, as always, lies with a disciplined research-driven investment process. In response to changes in the marketplace, we have sharpened 9% several elements of our process. However, the principle remains Equity Equity Currency Fixed Commodities Total Exposure Selection Management Income Management Return Display 2 Management* Value Returns Are Cyclical Value Underperforms 1¾ Pie years Labels 10% Disappointment borders for pies Series Corrective AND stacked bars Actions 0.75pt Average Length of Value Cycle, Anxiety Rising Source: AllianceBernstein Value Outperforms 4¾ years Hope Pie Labels Confidence Bar Label Actual Earnings and Stock Prices Series 1 Series 2 Series Overconfidence Bar break Average Line the same we rely on a combination of quantitative and fundamental research by a formidable team of in-house analysts to help us identify stocks that have succumbed to emotional biases on the markets and are likely to recover in the future. We want to understand the controversy that is causing a stock to underperform and be clear how it is likely to be addressed. Fear and Confidence Drive Value Cycles Yet even with the best research, certain market environments are much more conducive to value investing. The historic returns of value factors show a clear cyclical pattern (Display 2), amid fluctuating investor appetite for risk and changing sentiment on confidence in the future. Periods of unusual calm and optimism, like that which prevailed between 200 and 2007, are typically followed by periods of rising anxiety. Value tends to do well when anxiety levels are subsiding, as investors pay attention to the fundamentals of valuation. However, value often performs poorly when anxiety levels increase as in 2008 because value stocks 17% typically 100% have anxiety associated with them (Display21% ). These downturns then create the deep value opportunities 16% that generate high returns in subsequent periods. 7% As a result, despite six downturns in the Display9% Value Returns Have Overcome Previous Cyclical Downturns Equity Equity Currency Fixed Commodities Total Exposure Selection Value Management Factor Relative Income Returns* Management Return Colours Top Quintile Management* of Stocks Prefer white (9)% text on solids Trailing Earnings/Price (8)% Prefer black text on solids 10% Long-Term Earnings Power and Stock Prices Anxiety Falling max chart width incl labels axis label start 1 digit axis buffer the enduniverse for each factor 2 digit axis buffer Source: end Compustat, MSCI, Worldscope and Bernstein dig Chart fonts are 8pt Frutiger 47 Lt Cdn 4 dig example buffer Chart fonts are 8pt Frutiger 47 Lt Cdn *Hedged relative returns in USD, based on the Bernstein global large-cap universe of stocks, measuring the difference in returns of the most attractive 20% of stocks versus y-axis label 10 0 Trailing Earnings/Price Book Value/Price Book Value/Price 5% 7% Average Line Gridline Colours 1 2

4 value cycle from 1971 to 2008, stocks with the most attractive price/trailing earnings and price/book values outperformed the benchmark over the whole period by an annual average of 7% and 5% respectively. It s never easy to say with precision where we are in a value cycle. In 2004, for example, most indicators of the value opportunity were at very low levels. Investors then might well have concluded that a turn in the value cycle was close. In fact, value continued to outperform for another three years, and investors who moved out of value then would have left substantial returns on the table. So where are we now? By mid-2009 there were strong indications that markets were entering the early stages of a prolonged value cycle. As in previous cycles, rising anxiety in late 2007 and 2008 triggered severe underperformance of value stocks. This was followed by major corrective actions, by both policymakers and companies, which helped stimulate macroeconomic turnaround and a revival of earnings. Expectations of an improved economic environment and a return to profit growth helped reduce anxiety and value stocks began to outperform. This transition from anxiety to hope, driven by corrective actions, is characteristic of a classic value cycle. Of course, it is impossible to predict with certainty how long the cycle will last or how strong returns will be. But past experience suggests that valuations of many undervalued companies will continue to rebound and that a disciplined value investing strategy, using deep research to exploit the persistent emotional biases often reflected in stock valuations, will once again reward patient investors. n 4 Why Value Works

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