Value Strategy Has a Big Problem --- Munger's warning: 'Get used to making less.'

"Charlie Munger influenced generations of investors -- none more so than his partner at Berkshire Hathaway, Warren Buffett.

Munger's death doesn't just leave a void atop Berkshire. It also raises questions about how the value-investing style he championed might evolve when great companies at fair prices are harder to come by.

Munger pushed Buffett to pay up for quality businesses, steering him away from an early focus on the cheapest stocks. Together, they built Berkshire into a sprawling conglomerate with a massive stock portfolio and became two of the most legendary investors of all time.

Many investors agree that the years of ultralow interest rates following the 2008 financial crisis helped growth stocks trounce value shares, often identified as those that trade at low prices relative to their worth as measured by various financial metrics.

Falling rates make it cheaper for businesses to borrow, turbocharging growth. They also make stocks look more attractive relative to less-risky assets like government bonds -- but tend to boost shares of companies geared toward future growth more than underpriced value stocks.

Some now question whether value stocks can thrive anytime soon as the Federal Reserve signals it will start cutting interest rates this year.

In the months before his death, Munger acknowledged that the traditional hunting grounds of value investors had been picked over. The low-hanging fruit was gone, he said. Investors had almost no choice but to own a few richly valued tech behemoths just to keep pace with the market, he suggested.

"I think value investors are going to have a harder time now that there are so many of them competing for a diminished bunch of opportunities," Munger said at Berkshire's 2023 shareholder meeting. "My advice to value investors is to get used to making less."

Yet many of Munger's pupils are staying faithful to his investing playbook: identifying the fundamental value of businesses and betting big when opportunity arises.

Snapping up shares of mediocre companies trading at bargain prices was a technique Buffett learned from Benjamin Graham, the father of value investing and his teacher at Columbia University's business school.

The so-called cigar-butt approach had major weaknesses, Buffett later wrote: It didn't work well when investing large sums of money and was the wrong foundation on which to build an enduring business.

He credited Munger, who died Nov. 28 at age 99, with shifting his investment strategy and setting Berkshire on the path to the company it would become.

"The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices," Buffett wrote in 2015.

Today, Berkshire is the seventh-largest U.S. company by market value and operates businesses ranging from Geico to BNSF Railway to See's Candies that Buffett and Munger acquired using those value-investing principles. It also has more than $150 billion in cash and a stock portfolio of more than $300 billion featuring the likes of Coca-Cola, American Express and Bank of America.

Berkshire's own stock has crushed the market. In the 40 years through 2023, the S&P 500 rose nearly 2,800% on a price basis, according to FactSet. Berkshire, by contrast, soared more than 41,000%.

Munger's version of value investing has largely prevailed among bargain-hunting stock pickers. Prominent practitioners of the style say it evolved from the early days of identifying cheap stocks. In an age when millions of investors can access the same information, it's hard to be the first to identify a screaming bargain.

"The methodology of value investing has changed. You can't buy cigar butts anymore. They've been culled over," said Mario Gabelli, founder, chairman and chief executive of Gamco Investors. Gabelli, a longtime stock picking value investor, bought Berkshire's Class A shares through his Gabelli Asset Fund in 1985, for about $2,000 apiece. Today, they trade at more than $550,000.

Li Lu, founder and chairman of Himalaya Capital, a value-investing firm in Seattle, said Munger helped shift how the investing philosophy was practiced. Munger entrusted Li Lu to manage $88 million of his family's money in the early 2000s and once viewed Li Lu as a top candidate to manage Berkshire's portfolio.

"He is more responsible than anyone -- and even Warren would acknowledge that -- in moving the discipline of value investing from just simply buying cheap securities into buying and holding quality businesses for the long haul," Li Lu said.

Value investing once enjoyed a lengthy record of success. On average, value stocks outperformed growth by about 7 percentage points annually between 1970 and early 2007, according to an analysis from Goldman Sachs Asset Management.

But then the Fed slashed its benchmark rate to near zero when the financial crisis roiled the economy in 2008. After raising rates modestly in subsequent years, the central bank again cut them in early 2020 to support an economy reeling from the Covid-19 pandemic.

Low rates tend to help some stocks more than others. Growth companies are expected to significantly expand their businesses, raking in increasing amounts of cash down the line. The present worth of a value stock, by contrast, is usually weighted more heavily toward earnings in the near future.

That difference means that growth stocks can get an outsize jump in value when lower interest rates boost the worth of far-off cash flows.

The Russell 3000 Growth index, which follows companies that are growing at an above-average rate, has advanced about 700% over the past 15 years. The Russell 3000 Value index, which tracks companies that trade at lower prices compared with their book value and have lower expected growth rates, has risen roughly 200%. Companies that don't fall neatly into one category can belong to both indexes.

"Can't fight that math," said Bryant VanCronkhite, senior portfolio manager on value strategies at Allspring Global Investments. "Growth has had a tailwind due to the trend of lower interest rates."

That tailwind has contributed to the dominance of big tech stocks in recent years. From the end of 2019 through the end of 2023, Nvidia and Tesla shares soared more than 700%, while shares of Apple, Microsoft and Alphabet more than doubled. The S&P 500, meanwhile, rose 48%.

So what is a value investor to do? According to Munger, you might have to buy one of those tech giants.

"I think that the modern investor, to get ahead, almost has to get in a few stocks that are way above average," Munger told The Wall Street Journal in an October interview. "They try and have a few Apples or Googles or so on, just to keep up."

Berkshire has followed that playbook, amassing a position in Apple that was worth more than $156 billion at the end of September, by far its largest stockholding.

Since Berkshire first bought about $1 billion of Apple stock in early 2016, the share price has risen roughly 600%. At the time of Berkshire's initial investment, Apple shares traded around 10 to 11 times the company's last 12 months of earnings. Now, the stock trades at roughly 30 times trailing earnings.

The year 2022 seemed like it could be the start of a revival for value stocks.

The Fed, dead set on fighting inflation, started raising rates at the fastest pace since the 1980s. Markets swung to favoring investments that generated immediate cash.

Megacap tech stocks like Apple, Meta Platforms and Netflix dropped, dragging the S&P 500 down with them. The Russell 3000 Value index outperformed its growth counterpart in 2022 for the first time since 2016.

But the next year, an AI frenzy took over the stock market. Investors excited about developments in artificial intelligence piled into shares of big tech companies like Nvidia and Microsoft. The Russell 3000 Value index rose 9% in 2023, lagging behind its growth counterpart's 40% gain by the widest margin since 2020's record underperformance, according to Dow Jones Market Data.

"So-called growth-stock investing usually represents the triumph of optimism," said Howard Marks, co-founder and co-chairman of Oaktree Capital Management, known for his prowess investing in distressed securities and memos on market themes.

"The great thing about AI companies is you don't even have to think about cash flows. There's not a cash-flow story. It's a brave-new-world story," he said.

Many investors think it remains to be seen whether the AI craze heralds another sustained leg of leadership by growth stocks. Some see echoes of the late 1990s dot-com bubble in the degree to which tech stocks have powered the market lately.

Rob Arnott, founder and chairman of value-focused asset manager Research Affiliates, says investing in AI is tricky because it's too early to know which companies will emerge as winners. He expects value stocks to outperform growth stocks by as much as 8 percentage points annually over the next decade, in part because they look historically cheap compared with growth stocks after last year's AI mania.

"If there's any mean reversion at all, the returns [for value] will have to be stupendous," Arnott said, adding that the current spread between growth and value stock valuations is "close to unprecedented."

The Russell 1000 Value index traded at the end of December at 19 times its earnings over the past 12 months, compared with 35.7 for the Russell 1000 Growth index, according to FTSE Russell.

Some value investors now advocate for a sector-neutral approach to investing, meaning they invest in companies on the cheaper end of the spectrum in every industry. That includes sectors like technology, where few companies trade at what most investors would consider a cheap price.

"I fall on the side of implementing the value factor in a more industry-neutral way, to avoid these unintended biases toward one sector like retail," said Jason Hsu, chairman of Rayliant Global Advisors and co-founder of Research Affiliates. A value investor choosing among tech companies trading at expensive multiples will favor companies with strong cash flows and other quality factors, Hsu said.

Other value investors draw a hard line at buying pricey stocks, no matter the industry.

"Value investors have evolved into buying more expensive stocks," said John W. Rogers Jr., founder of Ariel Investments. "We haven't done that."

He sees opportunity in neglected value stocks, believing a lack of research around value companies is leading those firms to be misunderstood and mispriced. Rogers is bullish on cruise lines, housing-related firms, financial services and media and entertainment companies.

"Something that Charlie Munger used to talk about is that investment shouldn't be like Noah's Ark, where you own two of everything," he said. "We've tried to stay really focused and to know our favorite industries really in depth."

Nicolas Steegmann, a 34-year-old entrepreneur based in Columbus, Ohio, studied Munger's investing approach at Columbia Business School.

"Munger says a few major opportunities come across in a lifetime and you have to be prepared to jump on them. You have to wait for the odds to be stacked up in your favor," Steegmann said.

Taking that advice to heart, Steegmann said he bought shares in Google parent Alphabet in March 2020 when they dropped during the pandemic-induced selloff. Since then, the shares have nearly tripled." [1]

1. EXCHANGE --- Value Strategy Has a Big Problem --- Munger's warning: 'Get used to making less.' Langley, Karen; Miao, Hannah; Pitcher, Jack.  Wall Street Journal, Eastern edition; New York, N.Y.. 06 Jan 2024: B.1.