Value Investing Is Not Dead: An Eaton Vance Case Study


Value investing has been said to be in a slump. And if we just look at some value indexes and compare them to the S&P 500, it would show that value as a factor is underperforming. Below are 10-year, five-year, and one-year charts that compare the SPDR S&P 500 Index ETF (SPY), iShares Russell 1000 Value ETF (IWD) and Vanguard’s Value ETF’s (VTV) total returns over those time periods:

Data by YCharts
Data by YCharts
Data by YCharts

There’s little argument that can be made against the fact that value indexes and ETFs have underperformed the S&P 500 index since the bottom of the last cycle even on a total return basis. In particular, as we see above, the value category has significantly underperformed during the current recession. However, I consider myself mostly a value/GARP investor, and since 1/12/19, when I launched my Marketplace service The Cyclical Investor’s Club, my ideas have managed to modestly outperform the S&P 500 index even while holding 30% to 40% cash during most of 2020. I credit the effectiveness of a value/GARP approach for my being able to that, and I think it’s important to share my approach so that other investors understand there’s nothing broken with value and growth-at-reasonable-price investing. They are very effective strategies for medium and long-term investors if you know what you’re doing.

So, in this article, I’m going to do a case study of Eaton Vance (EV), one of my ideas that we recently took profits in. I typically don’t share ideas with the public for stocks that aren’t in the S&P 500, and reserve those the Cyclical Investor’s Club, but since EV is being acquired by Morgan Stanley (MS), and this investment has been realized, I see no harm in sharing it with the public as a case study so that I can explain some of the ins and outs of my particular approach to value and GARP investing. This is a case where I think the details really matter, and there are some tricks I use to enhance performance, which I think are really important and would like to share.

What I will do is take you through my approach and thought process back in March when I took my EV position, and then I’ll do the same again when I recommended the stock again on Sept. 10 for members who might not have bought in March. I’ll also explain why I have avoided Morgan Stanley during this time period. While the specific opportunity in EV has now passed, the method I used to identify the value in the stock can be repeated on other stocks.

Here’s my process:


Step 1: Have Cash

It’s pretty hard to buy stocks if you don’t have cash. I don’t use leverage, so having cash ready to deploy during recessions is important. Alternatively, selling an overvalued stock in order to buy an undervalued stock is an acceptable strategy too if one wants to totally avoid making any macro recession calls. For this particular downturn, I moved to about 80% cash on Feb. 28, 2020, and I wrote about that move the next day in my blog post “Recession Mode Is Here.” I remain about 35% cash right now because I wasn’t able to fully invest everything during the downturn, though I’m still buying stocks here and there when they look like good values. I have no problem being fully invested in stocks when I don’t think we are going into a recession, and I was fully invested during all of 2019, mostly via defensive ETFs, as I explain in my blog post linked above, but going into recessions, having cash or some other defensive position is important.

Step 2: Cyclical or Not Cyclical?

I have different strategies for finding value for different types of businesses. For businesses whose earnings are not highly cyclical, I use a pretty basic valuation approach that takes into account the price of the stock, earnings, and earnings growth. But in recessions, as we were in during March, I have some additional factors I include to help me get the very best values, and those additional factors are relevant for Eaton Vance. So it helps to know what part of the economic cycle we are in when making some of these decisions.

My standard for determining whether a stock is highly cyclical or not is whether EPS has dropped -50% or more in the past. I’ve circled the years where Eaton Vance’s EPS declined in the FAST Graph above. The deepest decline was -35% during the Great Recession in 2009. Since that’s less than a -50% decline, I treated Eaton Vance as a non-cyclical stock. If it would have had more cyclical earnings, I would have started with a different method of analysis than the one I’m sharing in this article.

Step 3: Determining Value

I consider there to be two main drivers of future total returns for non-cyclical stocks: Returns that come from market sentiment changes and returns that come from the business’s earnings and earnings growth. I estimate market sentiment returns by using mean reversion. The idea behind this is that at some point over the course of the next 10 years, the market is likely to value the company as it did during the last economic cycle. So I use the average P/E from the last cycle and compare it to the current P/E and determine the likely returns one might get if the P/E reverted to that long-term mean.

The first thing I want to note is the time frame I’ve chosen here. This FAST Graph runs from 2008 through 2019. I selected this time frame to show how I saw things back in March, and to understand what I saw, then we need to see the information I was dealing with at the time. This is really important because when you buy a stock during the beginning of a recession sell-off, you really never know how far the stock price will drop or how far earnings may eventually drop. I do my best to use history as a guide so that I can predict the best buy prices. I chose to go back all the way to 2008 because that captured the last recessionary period and essentially created a full cycle’s worth of data. (That’s why I call this a “Full Cycle Analysis.”)

The second thing I’ll draw your attention to is the average P/E ratio over the course of this cycle, which was 17.23. This is the average P/E ratio I used to make my mean reversion estimate.

The third thing is what I call the “Recession P/E Ratio,” which was 11.76 during the low point of the 2009 recession. This will come into play later in the analysis.

So, the first thing I want to do here since we are looking backward is to determine what the P/E ratio looked like when I bought the stock on 3/23/20. The key element here is that since I knew we were in a recession I used peak earnings estimates from February because if earnings eventually recovered from the recession, I assumed they were likely to recover to their previous peak before the end of the next cycle. At the time, before the recession, EV was expected to have earnings of $3.59 per share for 2020. Now they are estimated to be $3.35 per share, but back in March I didn’t know how much they would decline and what I really cared about was that they would eventually recover because I’m prepared to hold the stock over the course of the next cycle, up to 10-years, if need be, for that to happen. At the time, my buy price for EV was $24 per share. When I bought just below that price the P/E was about 6.69.

If over the course of a 10-year period, if the P/E were to revert from 6.69 to the long-term average from the last economic cycle of 17.23, the 10-year expected CAGR from that mean reversion would have been +9.93%. So that was the return I expected from sentiment mean reversion when I bought the stock in March. Next, let’s examine the returns I expected from the business earnings.

Step 4: Business Earnings Returns

We previously examined what would happen if market sentiment reverted to the mean. This is entirely determined by the mood of the market and is quite often disconnected, or only loosely connected, to the performance of the actual business. In this section, we will examine the actual earnings of the business. The goal here is simple: We want to know how much money we would earn (expressed in the form of a CAGR %) over the course of 10 years if we bought the business at today’s prices and kept all of the earnings for ourselves.

There are two main components of this: The first is the earnings yield and the second is the rate at which the earnings can be expected to grow. Let’s start with the earnings yield back on March 23. The earnings yield at the time was about +14.96%. The way I like to think about this is, if I bought the company’s whole business right now for $100, I would earn $14.96 per year on my investment if earnings remained the same for the next 10 years.

The next step is to estimate the company’s earnings growth during this time period. I do that by figuring out at what rate earnings grew during the last cycle and applying that rate to the next 10 years. This involves calculating the EPS growth rate since the end of 2007, taking into account each year’s EPS growth or decline, and then backing out any share buybacks that occurred over that time period (because reducing shares will increase the EPS due to fewer shares).

Data by YCharts

Overall shares outstanding since 2008 were essentially unchanged, so they didn’t need to be factored into the earnings growth rate. All I really needed to factor in were the years in which earnings declined, like the -35% earnings growth year in 2009. After doing that, I calculated a cyclically adjusted earnings growth rate of approximately +7.83% over the course of the last cycle, which isn’t super fast but is a relatively good rate.

Next, I’ll apply that growth rate to current earnings, looking forward 10 years in order to get a final 10-year CAGR estimate. The way I think about this is, if I bought EV’s whole business for $100, it would pay me back $14.96 plus +7.83% growth the first year, and that amount would grow at +7.83% per year for 10 years after that. I want to know how much money I would have in total at the end of 10 years on my $100 investment, which I calculate to be about $331.78 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +12.74% 10-year CAGR estimate for the expected business earnings returns.

10-Year, Full-Cycle CAGR Estimate

Potential future returns can come from two main places: Market sentiment returns or business earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years for EV, it will produce a +9.93% CAGR. If the earnings yield and growth are similar to the last cycle, the company should have produced somewhere around a +12.74% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +22.67% at the March 23rd price.

My Buy/Sell/Hold range for this category of stocks is: Above a 12% CAGR is a Buy, below a 4% expected CAGR is a Sell, and in between 4% and 12% is a Hold. Obviously +22.67% is well above my 12% threshold for a buy, so it was a clear buy at this price in March.

But this begs the question of why I didn’t buy the stock sooner? It clearly crossed my standard buy threshold at a much higher price. The answer to that is for Eaton Vance and a few other stocks I noticed that during the last recession the market tended to disproportionately punish the stock, and so, since I had determined we were going into a recession, there were two additional factors that I included before buying stocks that fit this profile.

Recession Factors

Remember that recession P/E number of 11.76 I shared earlier in the article? Since we were going into recession, I calculated that for all the stocks I was tracking back in February right as the market was peaking. My general rule was that I wouldn’t buy (even if the CAGR looked good) until I was at least within 20% of that recession P/E low. For example, if a stock had a recession P/E of 10 during the last recession, I wouldn’t buy it until the P/E fell to at least 12, even if the 10-year CAGR was over my 12% threshold.

With most stocks I bought near the bottom in March, that “Recession P/E” factor was the last to hit before buying, but with Eaton Vance, it even met the Recession P/E criteria pretty early in the sell-off, and I still didn’t buy it, yet. Here’s why:

Data by YCharts

The chart above is the price drawdown data for EV starting in 2007. I took note of the extremely big price drawdown of -75%, and I thought there was a chance that Eaton Vance could be disproportionately punished by the market during a recession as it was during the 2008/9 recession. Since this sort of price volatility is something I usually see in the stocks of businesses whose earnings are highly cyclical, I decided to use the technique I use for cyclical stocks to predict a good recession buy price for EV.

Since Eaton Vance had a high P/E of 37 while going into the 2008/9 decline, compared to a high P/E of about 22 going into the current decline, I figured that the 2020 decline was unlikely to decline over -75% off its highs as it did in 2008/9, so I decided that I would start a position at about -60% off the highs, and that worked out to about $24 per share. On March 23 that price hit and I was able to buy the stock a little under $24 per share. Here is the performance the position had from the purchase date through Oct. 8 when I took profits:

Data by YCharts

Even compared to the S&P 500 purchased at its cheapest this year, Eaton Vance outperformed all year, and then roughly tripled the performance of the index after Morgan Stanley’s buyout offer, returning a little over +160% in 7 months. Not bad for a value investor.

But wait, there’s more…

About every six months or so, I sort through about 300 non-cyclical stocks I track, and update my EPS and earnings growth estimates, as well as my “buy prices.” I performed that update last month. A lot had changed since February. We were now clearly in a recession, but it also was clear that both the Federal Reserve and the federal government were giving lots of support to the economy, and I expected that support to continue in early 2021 with a new stimulus package. This meant that I needed to adjust my expectations and that I should not expect recession-level “buy prices” anymore. As a result of that change in the macro environment, I both updated my EPS and growth expectations for the stocks I track, and also removed most of the additional recession factors I had included from February through September. Below is a Sept. 10 message I shared with CIC members regarding Eaton Vance after I ran the new numbers.

It’s very, very rare for me to suggest a stock is still a buy after the price has risen over +75% in six months’ time, but EV’s numbers weren’t lying. Let me share what I was seeing back on Sept. 10.

The FAST Graph above is slightly different than what I was looking at a month ago, but it’s pretty close. What’s important here are the changes from the analysis I ran in February. The first change is that since we were essentially in a recession now, I could start the cycle later, post the 2009 recession, so this time-frame starts in late 2010 instead of late 2007. This gets rid of a big -35% earnings decline but still includes three modest earnings declines. Where the current earnings back in February were expected to be $3.59 per share, in September they were $3.34 (now they have ticked up a penny to $3.35). Ultimately, taking this all into account I got an expected earnings growth rate of +6.46% for the next cycle, which was a little lower and more conservative than the +7.83% earning growth I expected in February, but it was still pretty close. Additionally, the new average P/E from FAST Graphs back in September was 16.33 (now it’s slightly lower at 16.21) and this was also lower and more conservative than my February number of 17.23, but the current P/E for EV at the time was 11.31 so it still would have produced a mean reversion CAGR of +3.74%.

At the price on Sept. 10, the earnings yield would have been +8.84%. Combined with the earnings growth expectation of +6.46%, it would have produced a 10-year business earnings CAGR of +8.53%. Putting the sentiment mean reversion and business CAGRs together we would have gotten +12.27%. And that’s the data I was looking at on Sept. 10 when I declared that EV was still a “buy.”

Fortunately, many CIC members who weren’t around in March were able to take advantage of that opportunity and they did quite well over the next 3-4 weeks after Morgan Stanley’s deal came.

Data by YCharts

Once again, not bad for value investing.

Why I Didn’t Buy Morgan Stanley in March

I have a general policy of simply taking profits when a stock I own is bought out, but if there are EV shareholders who are not M&A specialists, and who are trying to decide whether to keep their shares and have part of them converted to Morgan Stanley shares, I’ll share why I’m not interested in doing that, and why I avoided buying Morgan Stanley’s stock during the March sell-off.

Since I sift through thousands of stocks I have found it useful to develop a few simple parameters to rule potential investments out right away, and I’ll share a couple of them here. Since Morgan Stanley’s earnings are highly cyclical and fell more than -50% in both the 2001 and 2008/9 recessions, I use historical price cyclicality to guide potential entry points for the stock instead of using more fundamental earnings analysis as I primarily did with Eaton Vance.

Below is a long-term price chart of Morgan Stanley stock.

Data by YCharts

One of the parameters I require before potentially buying a cyclical stock like Morgan Stanley is that the peak price from the most recent cycle is higher than the peak price of the previous cycle. In Morgan Stanley’s case, its price peaked in 2000, then it had a lower peak price in 2008, and then yet a lower peak price in 2018. When this dynamic is combined with highly cyclical earnings, I would probably never buy a stock like this.

The one exception might be if all this price movement was completely arbitrary and disconnected from earnings. (Which actually did happen a lot in the 2000 bubble.) So, if earnings were making newer highs with each cycle, it might just be that the earnings multiple is coming down from an extremely high multiple in 2000 and that it has taken 20 years to do so. I can check this quickly using a FAST Graph.

The shaded dark green area on the graph represents the Adjusted Operating Earnings. As we can see, the 2007 earnings peak still hasn’t been reached, and EPS is expected to decline -3% next year. Overall, this is a profile of a company that could be in a secular decline. And in some ways, that explains the recent purchases of E*Trade and Eaton Vance. Morgan Stanley is trying to make moves in response to this potential secular decline. For what it’s worth, even at Eaton Vance’s current price (which has adjusted due to Morgan Stanley’s acquisition) I still have an expected 10-year CAGR for EV at 4.77% (and if we just took the business earnings portion of the calculation, which seems appropriate to do here, the CAGR is +5.94%). So, I think Morgan Stanley can get at least a 6% annual compounded return on their EV investment. In this expensive market, that’s not bad. The mid-range expected business CAGR of the stocks I track is about 5.50% right now (and I exclude all the companies that don’t have earnings and who don’t have five years worth of data). So, all in all, I don’t think Morgan Stanley is overpaying, and I’d say they are probably getting a fair deal.

That said, I still don’t usually invest in situations where a business has been on the decline for the past cycle or two (even if it’s just a modest decline in the case of MS). For that reason, I took profits in EV on 10/8/20.


I hope some of my regular readers who have read my more basic analyses were able to get a little more of some of the nuance that goes into my analysis with this article. While it’s true that the buyout from Morgan Stanley accelerated the gains of this purchase and that EV has been my biggest winner this year, we have realized a total of five 100%-plus winners this year, and are still holding 6 that are near or above 100% returns as well, so the Eaton Vance investment wasn’t an anomaly. On the losing side, we’ve had one realized loser, Bank of NY Mellon (BK), which I lost about -13% on, and which I wrote about a few weeks ago, Valero (VLO) which is down about -15% and wrote about last week, HollyFrontier (HFC), which is down about -10% and will probably write about next week, and an undisclosed microcap that was hit pretty hard by COVID shutdowns and is down about -24%. So, the value approach has produced a few moderate losers, but they have vastly been outnumbered by big winners.

While index value investing hasn’t performed well over the past decade, using value and growth-at-reasonable-price approaches when selecting individual stocks has paid off well this year, and I’ve been able to modestly exceed the performance of the S&P 500 while taking on far less risk. I’m still holding ~35% cash and hold no big tech or stocks of businesses without a history of producing profits. So I don’t think the performance of value indices and ETFs are representative of actual value investing right now. Value investing still works well.

Disclosure: I am/we are long VLO, HFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.