Value investing can be challenging, humbling, and even lonely, as fund manager Sam Peters has learned over the last three decades.
"This job requires an immense amount of humility," Peters said in a recent interview with Insider. "It gets forced on you because you're wrong so much."
However, Peters has also found that the rewards can be huge. The $2 billion ClearBridge Value Trust Fund (LMVRX) he's co-managed since 2010 has beaten 88% of its large-cap value peers in the last five years, according to Morningstar. That includes a top-11% showing in its category so far in 2023 — its best relative performance in a decade.
Markets are usually efficient, Peters acknowledged, meaning that stocks usually trade near their fair value. But there are many cases where investors are too pessimistic about a company, which opens the door for value-minded managers to score a sizable profit.
Contrarian investing requires conviction and patience. If an investment doesn't initially pay off, stock-pickers may begin to wonder who's crazy — the market or themselves.
"There are times where we'll do the very lonely thing," Peters said. "When things are so dislocated, we're the folks that'll step up and take the other side, but we clearly think the fundamentals are going to get better at some point."
How to find deeply undervalued stocks
Small discounts rarely catch Peters' eye. Instead, the manager looks for stocks that he believes are trading at about two-thirds of their inherent value, even if they're highly unpopular in the present.
"If price versus value is more than 30% away, we consider that an inefficiency," Peters said. "And typically, that comes up for behavioral reasons — either an overreaction in the short term to some pain, an earnings miss, or something where people are overreacting and price and value just get too dislocated — or when you're going through a big regime change in markets."
Peters later added: "I don't know what's going to happen in the future, but I want to be resilient to as many possible futures as I can. And if I'm buying things where the price is more than 30% below value, I'm demanding very little of the future."
Finding undervalued companies is both an art and a science, Peters said. The art side refers to his investment thesis, or why a stock is set to perform better than the market expects. He said he must point to specific events in the coming years that will either support or contradict his theory so that he can objectively evaluate his investment without getting swayed by emotions.
Of course, any sound investment thesis should be supported by data, like a company's projected growth rate and profit margins, Peters said. The fund manager added that he reverse-engineers discounted cash flow models to find stocks with subdued expectations that can outperform.
Thanks to this method, Peters' portfolio often has an unconventional combination of companies that offers diversification with the potential to compound abnormally large returns over time.
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"I can deliver a portfolio that doesn't look like anyone else's, but it's not Frankenstein," Peters said. "We understand when we have more diversification than the market, and we end up with that unique portfolio with very good portfolio construction."
While some fund managers focus solely on their process and tune out economic data entirely, Peters stays flexible. When growth rises or falls, he said he positions his portfolio accordingly by tilting toward either economically sensitive stocks or their defensive counterparts.
"In different market environments, we're going to adapt to that and see what we're getting paid for and adjust the portfolio across the market cycle," Peters said. He reasons that doing so keeps him from getting overconfident and making bad investment decisions: "I want to build a portfolio that is immune from my bad forecast because I know I can't forecast the future."
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A contrarian at heart, Peters said that while many investors get excited about the possibility of a soft landing for the US economy, he's bracing for turbulence with a more risk-off portfolio.
"People desperately want a mega-cap-growth-driven cycle, low inflation, a friendly Fed," Peters said. "I just don't think we're going to get it. I think COVID changed everything."
Peters added: "I think we're going to be in a higher nominal rate environment, higher inflation environment, higher rate environment. That's an entirely different macro environment than the last cycle, which was free money, zero cost of capital, very low growth, 2% real inflation, 4% nominal with no volatility — totally different environment."
Such a setup would favor value stocks over their growth peers, Peters said. But instead of getting overly excited, he's staying disciplined by prioritizing quality traits and cheap valuations, which are the biggest driver of equity returns in the long term.
Peters said he's bullish on healthcare stocks right now, specifically large pharmaceutical and biotechnology companies. Healthcare boasts defensive qualities, yet has remained cheap while investors seek protection in pricier sectors like consumer staples, he noted. Peters' top holdings in those groups are Johnson & Johnson (JNJ) and UnitedHealth Group (UNH).
Insurance companies also stand out as a discounted subsector within financials, Peters said, especially since they're one of only a few groups that benefits from higher costs of capital. The fund manager cited American International Group (AIG) as an example of a top name to own in the space. AIG is led by a capable management team yet trades right around its book value, he said.
"They're taking out the risk, cutting costs, and improving," Peters said. "The ROE is coming up, the volatility of their fundamentals have come out, and then I have the backdrop of a good insurance cycle that I mentioned because there's not enough capacity. Everybody's bringing back risk."
Lastly, Peters cited a pair of companies in the energy sector as among his favorite ideas now: Noble (NE) and EQT (EQT). Both are top-10 holdings in the ClearBridge Value Trust Fund.
Noble is an offshore drilling firm that has paid off debt after exiting bankruptcy and now has a fortress balance sheet, in Peters' words. Besides having substantial pricing power, Noble is generating enough cash to match its own enterprise value about every three years, Peters said. It also is rewarding shareholders by paying a dividend and buying back stock.
EQT is a top natural gas producer with a strong CEO in Toby Rice and a free cash flow yield of roughly 20%, Peters said. It has also made a remarkable rebound by paying down debt, which helped fuel its stock's rise from mid-single-digit levels at its 2020 doldrums to north of $40 today.
