Is value investing worth it?
By Myooran Mahalingam, Portfolio Manager — Global Equities and Global Listed Real Estate
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.
It worked through the 1920s when a lot of stocks were railroads, steel and steamship companies. It worked through the Great Depression, WWII, the 1950s, which included the space race and all the technology that spanned it. It also worked in the internet age.1
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 1926.2 However, value stocks generated an average return of 18.9% per year over the same time frame.3 Finally, the research concluded that value outperformed growth in roughly three out of every five years over this period.4
As for the current decade plus period of value underperformance versus 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.5 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.
Investors rediscovered the case for owning profitable companies with proven business models trading at discounts to both their cash flows as well as the broader market.
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.
Performance has been achieved without glaring style, country or industry biases. Instead, it has stemmed from taking measured risks across a broad spread of stocks over many countries.
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 when the bounce in value occurs, they can be front loaded (like what occurred when the technology bubble burst in 2000), and typically last for periods measured in years (Chart 1).
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.
Chart 1: Value returns can be frontloaded
US value cycle returns July 1973 – June 2014
|Cycle||Dates||Return in first 11 months||Return over full value cycle||Length of value cycle (in months)|
|1||Jul '73 – Mar '78||12.7%||127.2%||57|
|2||Dec '80 – Aug '88||23.0%||264.4%||93|
|3||Nov '90 – Aug '95||29.4%||131.3%||58|
|4||Mar '00 – Feb '07||55.1%||176.9%||84|
|5||Dec '08 – Jun '14||35.4%||107.5%||67|
Source: Pzena Investment Management analysis based on Sanford C. Bernstein research from Pzena Quarterly Report to Clients, Fourth Quarter 2016
Consistent with that, our global equity portfolio is well diversified by investment styles and philosophies and configured to deliver potentially strong returns irrespective of future style cycles.
At the same time, our conviction in value investing is firm.
Value investing has worked in the past and can do so again
Conviction in value equity investing, stems, in part, from ‘inefficiencies’ created by behavioural biases. People tend to extrapolate and assume that the future is essentially a straight-line continuation of the recent past. However, the future rarely develops in a straight line.
Mapping this behaviour to the current global equity market environment assumes that already expensive stocks will become more expensive, indefinitely. Not only does this seem a tall order, but is also challenged by another human trait – the search for bargains. This is where value investing has stepped up in the past, and can do so again, in our view.
Some of the 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.
Our 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.6 Riding the US market as it kept growing has been important for performance.
Value managers have generally been underweighting the US market in recent years and thus haven’t fully participated in its rise. This is understandable on valuation, active management, and diversification grounds.
It would be odd for value managers to be overweight in an increasingly expensive market. We don’t appoint active managers to hug country weights, and a near 60% weighting to one market smacks of single country risk, not diversification.
Incidentally, our growth managers too are currently underweighting the US. This says something.
Paralleling 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.7
The nearest equivalent 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.8
Admittedly there are significant differences between then and now. The likes of Microsoft, Apple, Amazon, Alphabet and Facebook, and a number of their technology industry counterparts, are commercially strong and profitable.
By contrast, many bubble-era technology stocks traded at spectacular earnings multiples despite never being profitable and consequently disappeared with the 2000 tech wreck. Even so, it’s difficult to imagine that today’s technology giants can maintain their recent meteoric share price rises.
There are a few other ways of conveying the present sky-high optimism around US technology stocks. The implied earnings growth in their price/earnings ratios are, on average, way ahead of sell-side earnings growth forecasts over one and three years. They truly are priced for perfection.
Chart 2: US technology related stocks are priced for perfection
Valuations vs implied and forecast earnings growth
|1-year forward Price/Earnings ratio||Implied earnings growth based on recent market valuation (% p.a.)||1-year forecast earnings growth (%)||3-years forecast growth (% p.a.)|
As of 20 April 2020
Netflix is another example. The content streaming company’s astronomical valuation exceeds the combined market capitalisation of Australia’s four largest banks (Chart 3), despite Netflix’s earnings being dwarfed by the banks’ earnings (Chart 4).
Chart 3: Netflix’s valuation is eye-popping…
Market capitalisation: Netflix vs four largest Australia banks ($A millions)
As of 20 April 2020
Chart 4: …compared to its earnings
Earnings: Netflix vs four largest Australian banks ($A millions)
As of 20 April 2020
Another example is electric car maker Tesla, majority owned by Elon Musk. Tesla boasts a market capitalisation greater than the combined market valuation of some of the world’s biggest auto companies (Chart 5), even though Tesla is a loss-maker (Chart 6).
On these trends, the S&P 500 Index will morph into the S&P 10 Index! When value managers process all this, their response is ‘something’s got to give.’
Chart 5: Tesla boasts a stunning market capitalisation…
Market capitalisation: Tesla vs other car makers ($A millions)
As of 20 April 2020
Chart 6: …although it’s currently a loss-maker
Earnings: Tesla vs other car makers ($A millions)
As of 20 April 2020
Historically large valuations gaps between expensive and cheap US stocks
But it’s so much more than a tech versus the rest story. Whatever way the 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.9 This gap is the widest in 20 years.10
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.11
So, what’s going on?
There are two possible explanations.
Firstly, low interest rates today increase the sensitivity of equity valuations to long-term growth expectations, supporting the elevated level of valuation dispersion. That is, the low discount rate is making the future value of cash flows more valuable, especially the cash flows of companies with a record of delivering above-average earnings growth.
Secondly, estimates suggest there is around a 10 percentage point difference in the return-on-equity (ROE) between the highest valued US stocks (median ROE of 23%) and lowest valuation stocks (ROE of 13%), which is the largest on record, and has expanded in recent years alongside the widening distribution of stock valuations.12
Said differently, investors are loving growth stocks more than usual, and hating value stocks more than usual.
The upshot 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 has been extreme.
Value companies delivering better business and financial results than implied by current doomsday pricing could be the change needed for improved performance from value stocks.
From our perspective, arguments against value investing and value stocks seem skewed, at this moment. Ironically, this brings us closer to the time when value can return to its place in the investment sun.
1 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.
2 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 on the long-term performance of US value and growth stocks 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.
5 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.
6 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.
7 Where to Invest Now. From fear to FOMO. Goldman Sachs Investment Research. April 28, 2020.
9 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.
11 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.
12 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.
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