Value Investing: Tools and Techniques for Intelligent Investment

Chapter 31. Cyclicals, Value Traps, Margins of Safety and Earnings Power^[31]

Several clients have raised similar questions after my recent value screenings. They point out that some of the names I find are commodity related/industrial cyclicals made to look cheap by cyclically high earnings (something we ourselves have warned of many times this year). Ben Graham was aware of just this kind of problem, arguing that stocks should be evaluated on average earnings (based on 'five, seven or preferably ten years') rather than on current earnings. We have incorporated this into our deep value screen, and find nine S&P 500 stocks, and 31 European stocks that appear on our screen to be exceptionally cheap.

• My screens are throwing up stocks that are perhaps what we might call 'illusory value' – that is stocks which appear cheap simply because they have cyclically high earnings that are about to crater. To some extent I don't worry overly about such situations. The very essence of the risk management practice embodied within the margin of safety concept provides us with a cushion against the worst effects of earnings disappointment.

• For instance, on average over 1985–2007, those value stocks that have delivered the worst earnings growth have still generated a return around the level of the average stock. Their low price effectively provided some protection against poor outcomes. In contrast, the glamour stocks that deliver the worst earnings growth end up showing an average return of just 2% ...