2015 will not go down as a vintage year for value investors. The prevailing market environment is one that has rewarded companies that have demonstrated short-term earnings growth, irrespective of their valuations and longer-term prospects – and indeed this is a trend that has only accelerated over the past 12 months.
As a result value has underperformed growth as an investment style for the longest period on record and, as you can see from the following chart, is now trading at the widest discount to growth since the dot-com bubble in 2000. So why has this happened? The simple answer is that, in an uncertain world, it is human nature to crave stability.
The combined efforts of the world’s central banks have created an unprecedented environment of ultra-low interest rates and ubiquitous liquidity – one corollary of which has been investors’ willingness to pay up for the prospect of growth or stable earnings. The upshot, as we recently noted in Rainbow worrier, has been an equity market that has become highly polarised.
Conventional wisdom has accepted the current environment of lacklustre economic growth as ‘normal’, which has led the market to ascribe a considerable scarcity premium to businesses offering the promise of near-term growth. Here on The Value Perspective, however, we care far more about the price we pay for future earnings and far less about the rate of expected earnings growth.
And, just as stocks that are ‘priced for perfection’ eventually disappoint, so stocks trading at a discount to their underlying businesses’ intrinsic value are unlikely to stay that way forever. Value as a strategy is built on mean reversion and the belief price and value converge over time. History certainly suggests the status quo is unusual and value should recover and outperform meaningfully over the long term.
The trouble is, as the economist John Kenneth Galbraith so beautifully put it: “There can be few fields of human endeavour in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present."
Galbraith wrote that decades before Amos Tversky and Daniel Kahneman coined the term ‘availability heuristic’ – the behavioural finance idea that human beings tend to ascribe greater significance to more recent events – and now, in this prolonged environment of abnormally low interest rates, investors have great difficulty imagining they can ever rise higher than 1%.
Yet just consider how unlikely the current environment would appear to most investors only a decade ago. Hyman Minsky, another economist, once wrote “The illusion of stability of the system will, over time, create its own instability” and, here on The Value Perspective, we would certainly argue the stability many equity investors have sought in so-called ‘bond proxy’ stocks is wholly illusory.
Galbraith’s “incredible wonders of the present” manifest themselves today as abundant liquidity, ultra-low interest rates and a willingness of central banks to do, literally, “whatever it takes” – often despite the potential negative longer-term consequences of their actions. As the gap between supposedly stable companies and everything else grows ever wider, so we grow ever more concerned about the former.
In equity investment, valuation always triumphs over quality because, as their valuations rise, stable businesses can become very dangerous investments. In our view, many investors are already paying too much for perceived ‘safety’ and ‘certainty’ of growth, dislocations have become extreme and the market’s eventual snap-back to its typical function as an arbiter of value should be profound.
So will value recover in 2016? Here on The Value Perspective, it goes without saying we hope so – but, equally, we know there are no guarantees. It is worth pointing out that, in value investing, there is a direct relationship between historic and future returns – indeed, the worse the short-term returns, the better the subsequent five years has proved.
At the same time, we would very much stress we are not saying value’s performance cannot grow worse in the short term – it certainly can and has done in the past. Of course, past performance – either good or bad – is not necessarily a guide to the future but, again, it is worth pointing out that value investing has displayed a consistent pattern of mean reversion over more than 100 years.
So this piece should not be taken as any sort of message on market-timing. We cannot know when the current trend will reverse or what the catalyst for that reverse will be but, given the scale of value’s current underperformance, we firmly believe its potential recovery is the most attractive investment opportunity for patient investors in today’s equity markets.
As a postscript, it is important to remember we will never catch the low. Sensible value investors will always sell too early when the wider market’s enthusiasm turns to euphoria and buy too early when stocks fall out of favour. However, by slowly building positions on the way down and slowly exiting them on the way up, we should deliver superior returns while lowering our average risk exposure.
Value investing’s major strength is a disciplined focus on buying attractively valued, out-of-favour companies at all stages in the investment cycle. Here on The Value Perspective, we seek to apply this approach consistently as, while we know it will not always be in favour, we also know that, over longer time periods, it has generated exceptional returns.