Scott Black of Delphi Management on the difficulty of value investing

CNBC

• Scott Black, the founder and president of Delphi
  Management, made a household name for himself by employing the
  value investing techniques pioneered by Warren Buffett and
  Benjamin Graham.
• However, during the ongoing bull market, value
  investing has systematically underperformed as market
  conditions have changed rapidly.
• Black explains why value has lagged the broader market
  so much over the last 9 1/2 years, and outlines what he’s done
  to combat the trend.

It’s a difficult time to be a value investor. And no one’s more
familiar with that fact than Scott Black.

Throughout the 9-1/2-year bull market, Black — the
founder and president of Boston-based Delphi Management — has continued to employ the
same strategies that have made him a household name over four
decades.

However, during this market cycle, those methods haven’t worked.
Or — perhaps more accurately — their returns have trailed the
market.

“If you look at any of the numbers, this is the worst period for
value investing, ever,” Black told Business Insider by phone.
“Value has systematically underperformed since 2006.”

Business
Insider / Joe Ciolli, data from Bloomberg

As the chart above shows, the Russell 1000 Value index has
trailed its Russell Growth counterpart by 130 percentage points
over the 9-1/2-year bull market. It’s also lagged the
benchmark S&P 500 by more than 50. In many
cases, that degree of underperformance will prompt investment
clients to look to put their money elsewhere.

But why has value struggled to keep up? An approach that involves
buying stocks trading below their intrinsic values and waiting
for them to rebound to fair value should work, theoretically.
After all, it’s just a version of the traditional buy low, sell
high mantra.

Value has systematically underperformed since 2006.

The answer is that this record bull market is anything but
normal. Stock valuations have long blown past conventional
benchmarks, and the mega-cap tech juggernauts that have driven
record-breaking performance seem almost invincible, regardless of
how expensive they get.

But what truly sets this market apart from history is the rise of
so-called passive investment and quantitative trading. Black says
this has created a situation where many stocks trade in herd-like
fashion, with their fates tied to the buying and selling of
exchange-traded funds (ETFs).

He says this is a serious detriment to value investors, whose
work often revolves around finding mispriced companies whose
fundamentals should be commanding higher stock valuations.

It also becomes an issue for value investors when people keep
pouring money into funds tracking major indexes. This pushes the
prices for the top performers — like mega-cap tech — even higher
and out of reach for value investors.

With all of that said, Black isn’t
seeing bad results. He’s just struggling to
keep up with a market that looks nothing like the one he cut his
teeth mastering.

Take 2017 for instance. According to Black, Delphi’s All-Cap fund — which seeks
value across the full spectrum of market caps — returned 14.4%
for the year. Meanwhile, he says the firm’s Small/Mid-Cap fund
fared slightly worse, returning 16%.

And while that seems like strong performance, note that the
S&P 500 rose 19.4% over the same period, while the Russell
1000 Growth index surged 28.3%.

“On an absolute basis, we’ve had good results, but we’ve
certainly lagged the indices,” Black said. “The S&P 500 is
cap-weighted, and the money is flowing into the biggest stocks,
which all have very high P/Es.”

A Warren Buffett disciple

Black’s current investment principles date all the way back to
the relationships he forged at Harvard Business School, where he
earned an MBA in 1971. It was through this extended network that
he was first exposed to the stock-picking theories of Warren Buffett — who himself was
informed by Benjamin Graham, the so-called father of value
investing.

While Black initially tried his hand at corporate finance, his
MBA program buddy, Robert Goldfarb, went to work for legendary
investor Bill Ruane. As it turned out, Ruane was close friends
with Buffett from their time together at Columbia Business
School. They developed their investing habits alongside one
another, with considerable overlap.

The money is flowing into the biggest stocks, which all have very
high P/Es.

The wisdom gleaned from Buffett and Ruane trickled down to Black,
who began religiously following a simple set of guidelines: Look
for high-return-on-equity (ROE) companies, strong balance sheets,
and low multiples.

As Black started to get more directly involved in professional
investing, he fine-tuned his methods over a series of years
before founding Delphi in 1980. That was around the time
Buffett’s principles were featured in the classic John Train book
“The Money Masters,” which
Black devoured.

He recalls that era as a particularly fruitful one for value
investing. With the rise of quant trading still decades away,
Black says the market was much more inefficient, which created
opportunities for diligent investors like him. Back then, it was
still possible to find mispriced stocks with big underlying
potential.

Now, Black says the rise of ETFs and passive investing has sapped
the market of those exploitable idiosyncrasies.

“It’s not as easy as it used to be to find individual
companies that are undiscovered,” Black said.

“And when people run for the exits, they’re going to dump
everything. It doesn’t matter if you’ve got a good
company. If It’s in one of these baskets and people trigger
the sale, it’s going to go down. It’s a big structural change
since the 2000 tech bubble.”

And while other value investors have adjusted their methodologies
over time — in many cases so they can include more expensive,
high-flying tech leaders in their portfolios — Black has stuck to
his guns.

He doesn’t buy any stock that’s trading at more than 13 times
future 12-month earnings. No exceptions.

Considering the average stock in the S&P 500 trades at
roughly 17 times, that’s a serious handicap in a market that’s
been grinding continuously higher for years.

It’s not as easy as it used to be to find individual
companies that are undiscovered.

Black notes that when the majority of shares are climbing, it’s
difficult to outpace the market, even if you’re picking the right
stocks.

“Over 95% of the companies are coming in with record earnings,
but it doesn’t seem to matter,” said Black. “We’ve not making any
fundamental errors, its just that value is really systematically
out of favor.”

How Black has stayed afloat, and the road ahead

To get an idea how difficult it’s been for Black in the market,
consider that the investment guidelines outlined above have kept
him from owning any of the index-leading FANG stocks (Facebook, Amazon, Netflix, Google).

And to make matters even tougher, Black acknowledges that Delphi
recently lost a big client that accounted for a large chunk of
the firm’s assets under management. As he describes it, the
client started doing quantitative-driven smart-beta investing
internally, and also pursued a shift away from US domestic assets
to emerging markets.

Yet Black and his colleagues at Delphi have forged ahead,
sticking by their staunch value principles.

And while Black admits the rise of indexing has made it difficult
for his stock picks to avoid mass selling, he also sees himself
as well-positioned for a major market downturn. The thinking
there is — if a stock is already trading at a cheap multiple, it
has less to lose during a sell-off, making it more insulated.

“You would think that with a lower P/E and price-to-book, that
would provide more stability on the downside,” Black said.

When this market event will occur is another matter entirely.
Black himself admits that — between strong earnings and a growing
economy — the current bull market could run a while longer before
suffering a meltdown.

In the meantime, Black can find solace in the fact that he does
own shares of Apple. The tech titan briefly dropped
into Delphi’s valuation sweet spot when it was trading at $108
per share, and Black wasted no time in loading up. It’s now the
firm’s largest holding, offering a profitable sliver of exposure
to mega-cap tech.

You would think that with a lower P/E and price-to-book, that
would provide more stability on the downside.

Beyond that, Black has managed to make due with his
bargain-hunting approach by buying what he calls “good companies”
— or those offering both attractive ROE and cheap valuation, as
outlined above.

There are no shortcuts at Delphi. They visit every company in
which they invest. And they’ve been known to grill everyone from
corporate marketing officers to human resource officials, all in
pursuit of well-run operations.

In the end, Black’s firm is still making money in the market.
Even though value is historically out-of-favor, Delphi’s guiding
principles have kept the ship afloat. 

Because, ultimately, value investing still works at its core.
It’s just that in this environment, it can be a frustrating
process marked by prolonged periods of underperformance.

And given Black’s 40-plus years of experience, he’s exactly the
type to stay patient. Because managing money is a marathon, not a
sprint.