A message from MLC Asset Management's Chief Investment Officer
Dear Advisers and Investors
This note, the third in a series that began in April, coincides with a delicate time in financial markets.
Markets were relatively stable in May compared to the rollercoaster of March and April during which share markets fell very hard and fast in one month, to then recover some lost ground in the following month.
Combined with the easing of lockdowns in Australia and across the world, it creates the picture of a world ever so slowly taking steps back towards a new normal.
While most will welcome the chance to catch up with nearby family and friends, and being able to sit down to restaurant meals, we believe it’s premature to conclude that normal service has returned to investment markets.
It would be more accurate to describe the current situation as a surface or superficial calm.
Economic uncertainty remains high and that translates to uncertainty for investors given the economic outlook is a key driver of investment returns.
A further reason for our caution is that the coronavirus remains unbeaten. To be clear, countries have achieved varying degrees of success in pushing down infection rates and Australia has done an especially good job. We’ll still be looking over our shoulders until the availability of a vaccine that can be rolled out globally.
On this basis, we’re assuming three possible futures relating to the interaction between the coronavirus, and societies and economies.
Investment portfolios prepared for many eventualities
Our first scenario assumes that the northern hemisphere summer, our winter, helps rid communities of coronavirus and there’s no second wave of infections. In this portrayal, company profits start to recover from next year.
Our second scenario assumes a mild second wave of infections across the world requiring the re-establishment of partial lockdowns. In this scenario, the disruption to economic activity is carried over into next year and company profits experience a second down year.
Our third and most severe scenario assumes a severe second wave of infections requiring full lockdowns and a very depressed economic outlook.
Geopolitical risks have also returned as on-off US-China trade tensions rise again, and Beijing has proposed new national security laws in Hong Kong bypassing the city’s government and threatening Hong Kong’s status as a financial hub.
All of this is a far cry from imagining what’s ahead as a single investment future. Our forward-looking scenarios assume multiple outcomes and the many possible asset class returns in each situation.
Armed with this information, we make judgements on where and how to invest our clients’ money. Mindful of the level of uncertainty ahead, we continue to emphasise intensive risk-management across our portfolios along with careful additions to risk assets.
We continue to have derivatives strategies in place to help protect parts of our portfolios against future share market falls. Derivative strategies are a form of investment insurance, a bit like car or home and contents insurance. If an event occurs – in this case, share markets fall, investors in our portfolios get paid.
At the same time, we are selectively buying shares and corporate bonds, but only after we’re highly confident that the potential rewards outweigh risks.
Whatever happens, our portfolios are ready because we prepare for the many things that can happen, and not just one possibility.
Persisting with value investing
I also want to unpack another issue that many advisers and investors have been raising with us: is value investing worth persisting with given value stocks have trailed growth stocks for more than a decade? Given the diversified nature of our portfolios, including style diversification, we have exposure to value managers and therefore stocks considered to be trading below their potential.
The short answer — value investing is worth it because it works.
Value investing doesn’t work all the time – no investment style does – but it has proved itself over a century of varying economic and technological backdrops.
A Bank of America/Merrill Lynch study covering a 90-year period quantified the success of value investing in the United States. It found that growth stocks in the US returned an average of 15.6% annually since 1926.1
However, value stocks generated an average return of 18.9% per year over the same time frame.2 Finally, the research concluded that value outperformed growth in roughly three out of every five years over this period.3
As for the current decade plus period of value underperforming growth — we’ve been here before. In the United States, value stocks, at one stage, underperformed for 15 successive years in the 20th century, only to return to form.4 There will no doubt be other periods of value underperformance as this century progresses.
Some critics read the last rites for value investing in the late 1990s as the internet bubble became increasingly inflated. The bursting of the bubble silenced many of those voices.
Yes, to diversification, no to style concentration
To be clear, we aren’t value investing cheer leaders.
Rather, diversification, in all its forms — by asset classes, geographies, risk categories, investment approaches, listed and unlisted, and investment managers and more — is what we stand for. It means that portfolios, including equity portfolios, aren’t hostage to a single investment idea or theme for return success.
In the global equity space, investment managers across the style spectrum manage a blend of growth and value stocks, as well as stocks with other characteristics, for our clients.
Performance has been achieved without biases. Instead, it has stemmed from taking measured risks across a broad spread of stocks over many countries, global industry sectors and investment styles.
Finally, diversifying across the global equity universe has contributed to delivering a smoother return profile than could have been achieved by investing in any single investment style. That said, investors are forward looking and are legitimately wondering when value will take its place in the investment sun again.
Timing style cycles is notoriously difficult and so it’s not something we rely on. We recognise that value returns are uneven and tend to be especially strong in the early stages of the style’s recovery.
In other words, being underweight value, in the hope of hopping on board when the time is right, can be very costly. The value train may have already left by then.
Value investing has worked in the past and can do so again
Some commentary on market performance can create the impression that it’s solely the strength of the US market and some of its technology stocks that has driven the current ‘quality growth’ and ‘momentum’ cycle, leaving value investing behind.
However, analysis makes clear that the value style’s underperformance since the GFC is widespread covering Japan, EAFE (Europe, Australasia and Far East), Australia, and of course the US and the global share market (as measured by the MSCI All Countries World Index).
But as with so many things involving investment markets, the spotlight falls brightest on the United States.
The US weight in the MSCI All Countries World Index has risen from a little under 45% at the end of 2009 to a little under 60% by the end of last year.5 Riding the US market as it kept growing has been important for performance.
Value managers have generally been underweight the US market in recent years and thus didn’t fully participate in its rise. This is understandable on valuation, active management, and diversification grounds.
Incidentally, our growth managers too are currently underweight the US. That says something.
In parallel with the outsize growth of the US share market is the reality that the top five US stocks by market capitalisation — Microsoft, Apple, Amazon, Alphabet and Facebook — represent a stunning 20% of the US S&P 500 Index.6
The nearest parallel was the late 1990s tech bubble era when three technology stocks (along with two non-technology stocks) — Microsoft, GE, Cisco, Intel, and ExxonMobil — represented a similar portion of the S&P 500 Index.7
Current valuations for a number of other high-profile US technology companies are in the eye-popping category.
Streaming service Netflix’s market capitalisation exceeds the combined valuation of Australia’s four largest banks, despite Netflix’s earnings being dwarfed by the banks’ earnings.
Electric car maker Tesla, majority owned by Elon Musk, boasts a market capitalisation greater than the combined market valuation of some of the world’s biggest auto companies, even though Tesla is a loss-maker.
Companies like these are priced for perfection and managers who have avoided them on valuation grounds have paid a price.
But it’s so much more than a tech-versus-the-rest story. Whatever way this onion is peeled, it essentially shows the same thing — valuation differences between the most expensive group of US stocks and the least expensive are amongst the widest in history.
For instance, stock valuation dispersion is extremely elevated today even within individual sectors. The collective top 20% of stocks from every S&P 500 sector trade at a median multiple of 27 times earnings, while the bottom 20% of stocks with the same sector composition trade at a multiple of 9 times earnings.8 This gap is the widest in 20 years.9
Analysis through the lens of well-known valuation factors tell similar stories.
On a price-to-book basis, excluding the 5% largest US stocks by market capitalisation as well as the top 10% most expensive price-to-book US stocks shows spread differences are amongst the widest in history. Same story with price-to-sales, and price-to-book after excluding Technology, Media and Telecom stocks.10
One consequence of all this is that value stocks are priced for doom.
As can be imagined, it’s excruciating for value managers and value investors. And yet, it has usually been the historic case that value stocks begin to gain better market recognition when the despair around them is extreme.
Value companies delivering better business and financial results than implied by current doomsday pricing could be the catalyst for improved performance from value stocks.
From our perspective, arguments against value investing and value stocks seem skewed, at this moment.
Diversification across many dimensions is one of MLC’s investment bedrocks as we believe it serves clients well through changing market environments. It reflects our risk-management heritage and the care we exercise in managing clients’ funds.
Being faithful to this heritage has enabled us to steer clients’ portfolios through many investment cycles and market events since 1985.
We believe holding fast to time-honoured investment principles will again get our clients’ portfolios to what lies beyond the current market situation.
Chief Investment Officer, MLC Asset Management
1 Is Value investing ready to outperform Growth? By carvil, March 3, 2020. https://compounding.works/is-value-investing-ready-to-outperform-growth/. Accessed 22 May 2020. Data in the Bank of America/Merrill Lynch study cited in this article was updated in The Longest Pictures, Global Investment Strategy. BofA Global Research, Global Investment Strategy, May 13, 2020
4 This finding is from Value Is Dead, Long Live Value By Chris Meredith, July 2019 of O’Shaughnessy Asset Management, referred to in Has Value Investing Stopped Working?, Simon Moore, Senior Contributor, Forbes, November 25, 2019. https://www.forbes.com/sites/simonmoore/2019/11/25/has-value-investing-stopped-working/#288098719d95. Accessed 22 May 2020.
5 Source: MSCI and FactSet Research Systems Inc., trading as FactSet, is a financial data and software company headquartered in Norwalk, Connecticut, United States. The company provides integrated data and software. MLC Asset Management Services Limited subscribes to data made available by FactSet under a licence agreement
6 Where to Invest Now. From fear to FOMO. Goldman Sachs Investment Research. April 28, 2020.
8 US Macroscope: The haves vs. the have-nots: A closer look at the extreme valuation dispersion across US equities. Goldman Sachs Portfolio Strategy Research, May 14, 2020.
10 Is (Systematic) Value Investing Dead? Cliff’s Perspective, Cliff Asness, AQR Capital Management, May 8, 2020, https://www.aqr.com/Insights/Perspectives/Is-Systematic-Value-Investing-Dead. Accessed 22 May 2020.
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