Value – Time to shine on the global stage!

Value – Time to shine on the global stage!

8 Jun, 2017 | Market Insight

This week Robert Swift takes a look at how growth and value strategies have performed historically and how he sees them performing going forward.
There is no “right way” to invest. Many approaches can work and many styles or philosophies (growth, small cap, value, contrarian etc) all have their moment in the sun. Some strategies work better than others in that they are both less volatile (work more often) and offer more opportunities to the active manager in so far as they better identify high stock return dispersions  = the survivors win big and the losers lose all.

The strategy which seems to work best and offer the most opportunity for active management is value.

This value bias however comes at a price. While value investors expect to have the last laugh they sure miss out on a lot of laughs in the meantime. Put another way there is ultimately a risk and return benefit to being careful about the price you pay for investments, and for wanting dividends, but you do miss out on bragging rights at the cocktail party in that you probably don’t own a ‘sexy stock’.

At the moment on a global basis, value is not in the sun but in the shade. We show the extent to which growth is currently more popular than value right now in the chart below. This traces the compound return of the S&P global growth index (blue) and the global value index (orange) in the last 10 years.

Growth is ahead by a handy amount and so one would prefer to use a growth approach right?

Probably wrong – you should never drive looking in the rear view mirror.

S&P Global Growth vs Value Graph

The logical conclusion actually, is that the value risk premium is now much higher than the growth risk premium. In other words, value stocks are more likely to outperform from here given relative valuations. The time series returns are starting point dependent so only going back 7 years would show value outperforming. It is this starting point dependency that illustrates the mean reversion of the styles.

Going back 20+ years growth wins quite handily with about a +1% pa excess return over value.

We try to show the benefits of having a value bias in the bar chart graph below which sorts stocks by P/E ratio and then their subsequent returns. It doesn’t look sensible to buy high P/E stocks and yet that is what growth stocks are now – on high P/Es.

Value investing is possible because capitalism allows companies to enter and leave businesses. New capital will flock to industries in which there are above average returns on capital and will leave those with below average returns. Growth stock industries attract new capital which drives down returns or causes enormous cash investment to remain ahead of the curve. In such cases there is little room for dividends which are a large part of the total return equation. Value stocks tend to be the opposite. Investors like to be with the crowd and so tend to ‘flock’ to growth stocks as they run up. It can all end in tears. The challenge is to remain immune from the fear of being unpopular and even looking stupid as the growth party rocks on.

More subtly some investors argue that it doesn’t matter whether growth or value wins. It is often beneficial to use both approaches with an active manager in each, since the return series are diversifying. As long as both styles avoid stock disasters, the combination of styles can be powerful. More on that in later articles.

S&P500 Index Returns Chart

​The extent to which growth and momentum investing has gained an irrational upper hand can be seen in the following extract from a recent Bloomberg note.

“Investors may have borrowed money to chase the rally in the Sexy Six (Amazon, Apple, Facebook, Google, Microsoft and Netflix), resulting in a record amount of margin debt in March, Ned Davis, a strategist at the name-sake research firm, writes in a note. * Six stocks up 9.2% on a cap-weighted basis from March 1 to May 19, versus -1.8% for the rest of the S&P 500 * “The concentration in this bull market has been extraordinary, and that could be a sign of speculation and the type of narrow leadership seen in the late phases of bull market.”  –  Bloomberg

 Value investing tends to come “at a price”. That is there are certain consequences of using such an approach and while the dividend yield is higher and the asset backing security greater, there are consequent sector exposures and periods of doubt or underperformance. We list the major characteristics of value styles below.

  • They tend to perform better in economic uptrends with rising interest rates. Are we there now?
  • Stocks usually more cyclical in nature. Other investors underestimate the earnings leverage and a change in fortunes can run for many years in a positive way.
  • Sectors favoured tend towards banks, insurance, telecoms, construction and utilities. These are not ‘sexy’ and the cocktail party chat is limited! It was actually the GFC and the subsequent years of enormous bank penalties and restrictions, that hurt a large part of the value index return. That period is likely to be over.
  • Attraction of low PE investing is that idiosyncratic risk or cross sectional vol of universe is greater. That is stock picking is more rewarded. (As written in Anna Karenina – All happy families are alike but all unhappy families are unhappy in their own way – who knew Tolstoy could be quoted with reference to value investing)
  • It is the reinvestment of the higher dividends that compounds up. Dividends are proof of cash flow.
  • Value tends to perform better in periods of higher M&A as it is the lower rated stocks in any given sector that tend to be acquired.
  • Tends to be characterised by higher dispersion of return – the stocks have more volatile beta, higher financial gearing and some of the value stocks never make it back since their businesses are fundamentally obsolete. These are known as value traps and the usual story is that of buying a horse drawn carriage in 1920 as they became cheaper and cheaper. There was no price at which it was right to invest – the industry was dead.Some would argue the car industry is dying now as we move to driverless cars. We will see.
  • To avoid value traps it is better to combine a low PE strategy with positive earnings revisions or some evidence of management and strategy change such as disposals or acquisitions and we do use this in our fund management research. Cheapness alone doesn’t do it. It is “Cheapness AND Change”.

Current low P/E stocks where we see change, and which we own are:

Valero – The world’s largest refining company benefitting from lower feedstock prices and the shale boom in the USA.

Glaxo Smith Kline – A UK based leading global drug company under new direction as it seeks to emphasise its consumer products division, and to get a better payback on its high R&D budget.

Cisco – A USA based company shifting from a dependency on hardware sales to a service and software business model.