Finding Value in an Overpriced Stock Market

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Behind the Ugly Red Door

vitalyBy Vitaliy Katsenelson CFA

I am about to write a quarterly letter to clients, telling them that despite all the giddiness in the stock market, we are in Value Investor Second Hell. This is not the first hell; that one is reserved for value traps — stocks that look cheap based on past earnings but whose earnings are about to disappear, whereupon the stocks will permanently decline.


The second hell is when you cannot find value. I recently read a study that said the difference in valuation between the cheapest stocks (the lowest 10 percent of the market) and the rest of the market is the smallest it has been in more than 20 years. Of course, the market overall is very pricey; finding undervalued stocks in this environment has become increasingly difficult.


To adapt, you need to understand that there are two types of value stocks. The first are statistically cheap — their cheapness stares you in the face. This breed is quickly becoming scarce; even Hewlett-Packard Co. and Xerox Corp. are now found in growth investors’ portfolios. But before I talk about the second type of value stocks, let me tell you how my wife and I bought our house.




It was 2005. The housing market in Denver, just as in the rest of the U.S., was getting bubbly. Our family was about to grow, though we did not know it yet. We had sold our condo and were renting month to month and thus were under no pressure to buy a house, but we were keeping our eyes peeled for the right one at the right price. It was a nine-month journey. We even made some offers (usually below the asking price), which the sellers laughed at. They were right; their houses sold above the asking prices in just a few days.


I vividly remember how we finally found our house — and I have to admit it was entirely my wife’s doing. We were flipping through photos of house listings that met our criteria. We stumbled on a picture of an ugly green house with a bright red garage door, which had been on the market for six months. I made a snarky comment that this house would be on the market for another six months and was about to click to the next, but my supersmart wife said, “Wait.” She skipped all the pictures of the ugly outside and zeroed in on the photos of the interior of the house.


To my great surprise, this ugly duckling was ugly only on the exterior and had been completely redesigned inside. It was a perfect house for us. Since it had been on the market for a long time, the seller was willing to accept our low offer. I, like everyone else who did not buy this house for six months, was turned off by an ugly outside (which could be easily corrected with some paint) and failed to look deeper.


Back to the stock market. The other breed of value stocks are the ones with “ugly green paint jobs and bright red garage doors,” the ones that look unappealing from the outside and aren’t even cheap, at least not according to the statistics at everyone’s fingertips. Often, backward-looking statistics don’t capture such companies’ true earnings power, as it has yet to show itself. These are the stocks you should patiently seek out, especially in today’s value-deprived environment.




A stock that comes to mind is Micron Technology, a maker of memory chips. Micron has destroyed more capital over the years than Communism and Socialism combined. To be fair, it was not Micron’s fault: Its profitability — or lack thereof — was determined by its industry. Micron was a large player in a very fragmented business that Asian governments thought was strategic to the development of their countries, and so they subsidized their local companies. The memory industry was ridden with overcapacity. But nothing transforms an industry better than a financial crisis. The 2008–’09 global recession weeded out the weak players, and Micron bought the last one, Elpida Memory, in 2013 on the cheap, almost doubling its revenues.


Now the DRAM industry has only three players: Micron, Samsung and SK Hynix (a South Korean version of Micron). NAND memory (used in flash and solid-state drives) has the same competitors plus SanDisk Corp. Barriers to entry are enormous — a new entrant would have to spend billions of dollars on R&D and then tens of billions on factories. Therefore this cozy, oligopolylike industry structure is unlikely to change. Samsung, the largest player in the space, has an extra incentive to keep chip prices high because they give it a competitive advantage against Apple and, more important, against low-end Chinese smartphone makers that have to buy memory at market prices.


Gross margins of all memory companies have been gradually rising and still have significant room to grow. If Micron achieves its target margin level, in the mid to high 40s, its earnings will hit $4 to $6 per share in a few years, giving it a modest price-earnings ratio of 4 to 5 times. This is one cheap “ugly green paint job, bright red garage door” stock.


Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.


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Risk Management, Liability Insurance, and Asset Protection Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™8Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

I have read these texts and used consulting services from the Institute of Medical Business of Advisors, Inc., on several occasions. 

MARSHA LEE; DO [Radiologist, Norcross, GA]


One Response

  1. Agreeing …. to Disagree

    It is very comfortable and enjoyable to own a company everyone loves. You can brag about it to your neighbor, bring it up at social gatherings. But there is usually a significant price to pay for that comfort – the stock is fully valued. This is why value (cheap) stocks have historically beaten the bejesus out of growth stocks. The reason is very simple: Both love and discomfort are priced into stocks. Love is priced into fancy valuations, and the hated ones are cheap.

    This instinctive comfort-seeking doesn’t stop with stocks; it spills over to the people we choose to share ideas with. As investors, we tend to look for people who share our views, but we should do the opposite. During the 2012 Berkshire Hathaway annual meeting, Warren Buffett said something that really resonated with me while answering a question about his political views’ impact on Berkshire: “If you are going to choose your friends and your investments by if they agree with you, you are going to have a very peculiar life.”

    Let me tell you a true story (as opposed to just lying to you). I have a dentist friend who was born in Russia and lived in Israel and Germany before moving to Denver about 13 years ago. He is extremely smart, very well-read and a thoughtful person. However, I have yet to meet anyone with whom I have disagreed more about politics. His arguments with me are passionate but also well thought-out and backed up with facts and his own theories. In the past, I used to get angry at him. After one of our regular debates, I’d sometimes go into avoidance mode for several months.

    Three years ago my friend invited me to go skiing. Overall, he is a pleasant person, but I was a bit hesitant. It is a two-hour drive each direction from Denver to the mountains, and I did not think I could take four hours of arguing. But that day I felt extra masochistic, and I went along.

    Instead of debating with him, I started to listen. I made an effort to keep emotions to a minimum; I tried to identify the specifics of our disagreements, what assumptions both of us were making. And then I attempted to focus the discussion on these more precise points of difference. In the end, we each learned from the other. Our views have not changed much (political views, like religious beliefs, are nearly impossible to shift). But we’ve been skiing almost every winter weekend since, and in the summer we bicycle together. Now I always look forward to our disagreements – and we are much closer friends than ever.

    This lesson applies to investing. When you are long a stock, you are naturally trying to seek out investors who share your opinion, and you naturally stay away from those who have contrary views. This is the comfortable thing to do. Instead, we should try to do the opposite, to look for smart people who, after doing their research – a very important point – come to a different conclusion from ours.

    The idea becomes a bit more nuanced. If I talk to a momentum growth investor about a cheap value stock that has gone nowhere for years, I know exactly why he’ll be avoiding it: There is no momentum in the stock price. His view will bring me very little insight. However, the perspective of a smart fundamental investor who’s done thorough research but arrived at a contrasting assessment might be very valuable.

    When we find someone who disagrees, we need to identify exactly where the differences in opinion lie and then methodically and objectively try to refute those points. If you cannot, maybe you are not as right as you thought you were.

    In Creativity, Inc., Ed Catmull, co-founder and president of Pixar Animation Studios, discussed the process of making movies. He emphasized an important point: All of Pixar’s films – the ones we have come to love – in their early stages of development sucked (his word, not mine). To get them from suck to unsuck took a candid (Catmull stressed the importance of that quality) and collaborative process in which a group of executives and animators not working on the movie provided feedback to the ones intimately involved with it.

    I suppose that if Pixar’s creative team had only been looking for feedback that they agreed with, Toy Story and all the other great movies that followed it would never have seen the silver screen (and my kids’ lives would not be the same).

    It is psychologically difficult to intentionally search out opinions that are contrary to ours, but we need to condition ourselves to realize that a stock doesn’t know who loves it or hates it; in the long run, stock prices will follow fundamentals (earnings and valuations), and that is what contrary opinions may help us figure out.

    Vitaliy Katsenelson CFA


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