Value investing uses the earning power of an investment to calculate its value. We estimate how much an investment can earn over time and then discount that back to the present to arrive at a value for the investment.
The critical question is how much that business will earn over time. For it to be a value investment, we want to pay less than the value of the earnings.
Deep value investing, in my view, adds a wrinkle beyond the business selling for less than the value of the earnings power. For it to be a deep value, we want the investment to sell at less than half its value. That level of value gives the investor a margin of safety in case earnings do not immediately recover.
Consider this example: If we buy an investment at 1/3 off its value then we can achieve a 50% return. However, if we buy that same asset at 50% off its value, then we can achieve a 100% return. This is the magic of compounding in investing and why it pays to look for deep value.
In 2021, sector after sector have failed and experienced losses of up to 60% or more. Meanwhile, the major indices such as the NASDAQ 100 and the S&P 500 have continued to set new highs through most of the year. In my opinion, there may be indications that a bear market is developing.
First, the percentage of stocks now participating in the rally has fallen off greatly. At the end of September, the NASDAQ and S&P 500 had less than 35% of stocks in strong uptrends, according to my research. Secondly, throughout the year, safe-haven assets such as gold have continued to strengthen and draw liquidity from the broad market.
We have had more than a decade of underperformance by international developed markets, emerging markets, and commodity producers. As a result, these areas are now relatively cheap versus US markets.
Separately, governments are planning to increase their level of deficit spending to embark on infrastructure investments and a transition to clean energy. In my view, this increase in fiscal spending may awaken the long-dormant inflation genie.
Since the commodities markets peaked in 2011, the US stock market is the only market that has done well. Where the US markets have gone up over 300% since 2011, international developed markets such as Europe are up a little over 80%, according to my research.
Emerging markets and commodity producers have done much worse. Emerging markets are up about 40% while copper, gold and energy producing companies are all negative over the past 10 years. The commodity producers are negative even with the massive run up this year on inflation concerns.
In my opinion, the following sectors are where to find value opportunities: international developed markets, emerging markets, and producers of copper, energy and gold/precious metals.
The copper and energy markets are likely to do well in particular in my view because of the focus on greening the environment. Gold and the precious metals producers may do well as inflation takes hold more firmly and investors seek to preserve the purchasing power of their wealth.
Photo Credit: Bonnie Moreland via Flickr Creative Commons
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