Quarterly letters

Value Perspective Quarterly Letter – 4Q 2016

31/12/2016

The Value Perspective team

In 1897 the American novelist Mark Twain was in London as part of a global speaking tour.  A rumour was started that he was gravely ill, followed by a rumour that he was dead. The story goes that an American newspaper printed Twain’s obituary. According to widely-repeated legend, when asked about this by a reporter Twain said:

“The reports of my death have been greatly exaggerated”

What does this have to do with investing and value in particular?  Having underperformed growth for the longest period on record, value has enjoyed a resurgence in recent months. This has not gone unnoticed, with the ‘rotation in style’ garnering much attention in the financial press. Dislocations between cheap and expensive parts of the UK equity market had become extreme, and in some areas the markets snap-back to its typical function as an arbitrator of value has been profound. This has led some commentators to declare that value’s outperformance of growth is complete, and the mean reversion is over.

Source: Schroders, Thomson Reuters Datastream, MSCI World Value Index Net Return vs. MSCI World Growth Index Net Return, 31 December 2016

Let’s not get ahead of ourselves. The above chart shows the performance of Value vs Growth since 1974. Look on the far right hand side of the chart and there is a small uptick. That is value’s ‘recovery’. As things stand, we’re still just shy of two standard deviations away from the long-term average. It will take more than a few months to unwind the value styles so-called ‘lost decade’. Value’s recent recovery is nascent in the context of history. Reports that investors have missed it are, much like Twain’s death, greatly exaggerated.

 

Three important investment lessons to take from 2016

  1. The folly of forecasting

Macro-economic forecasting is very difficult, and even if you get it right the market can move in the opposite direction to what you believe is appropriate. Brexit and the US election results foxed the pollsters. But even if you had known the result of the EU referendum and the US election in advance and with absolute certainty, what good would it have done you as an investor?

It was widely believed that both eventualities would be bad news for equities. However, the market took just a couple of weeks to bounce back from its post-referendum losses, and not even a day to account for Trump’s impending residency in the White House before resuming its march towards all-time highs.

 

  1. Don’t look for catalysts and ignore any narrative – just focus on the numbers

Certain corners of the press would have you believe that the election of Donald Trump has been fantastic for value investors. Trump has said he is going to spend money on infrastructure, which means increasing government borrowing, which means bond yields will go up, which leads to inflation, which for a number of reasons tends to be good news for value. This is the narrative; the problem is it doesn’t fit the facts.

Value began to outperform growth in February – months before Trump was even confirmed as the Republican Party’s nominee. The Trump explanation for value’s recent resurgence versus growth is a classic example of the ‘narrative fallacy’. The reality is much more prosaic. Just as stocks priced for perfection eventually disappoint, stocks trading at a discount to the fundamental value of their underlying businesses are unlikely to maintain that discount forever. Value investments had become so cheap and underperformed for so long that their discount to growth had simply grown too great for the wider market to ignore.

People like a story, and desire a catalyst to rationalise something happening but that does not mean that one exists. Even with 10 months of hindsight, we are unable to pick out a particular number on a particular day and say, ‘that is why value started to outperform’.

 

  1. Safety stems from the price you pay, not the underlying dynamics of the businesses you buy

In addition to unpredictable events and value’s resurgence, a third big investment theme of 2016 has been the market’s obsession with supposedly ‘safe’ and ‘stable’ equities. As we noted in our letter to investors at the end of last year:

‘The gap between those companies that are reassuring and everything else is getting wider and wider, and we are increasingly fearful of the former. In equity investment, valuations will always triumph over quality. Safe and stable businesses can become very dangerous investments as their valuations rise. It is our view that many investors are already paying too much for this perceived ‘safety’ and ‘certainty’ of stable earnings. Dislocations have become extreme and we believe the market’s eventual snap-back to its typical function as an arbitrator of value will be profound.’

The ‘bond proxy paradox’ will be familiar to regular readers of our letters. If refers to our belief that ‘the hunt for supposedly safe and stable stocks since the credit crisis has pushed up the valuations of these stocks to a point where they can really no longer be considered safe or stable.’

And that is rather the point. In investment, there are no equities that are always safe or always risky. There are only equities that are too cheap or too expensive. A business could have the most volatile earnings stream in the world but, if you buy it at a 90% discount to fair value, you are giving yourself a very good chance of making money from that investment.

In the same way, you could identify the business that boasts the most stable earnings stream in history and yet, if you pay 10 times what it is worth, you are highly unlikely to make money. In fact you are more likely to end up losing money. To us, that is the definition of risk and it has nothing to do with the supposed predictability and stability of an asset – only the price you pay for it.

And so what was widely perceived to be safe in the summer of 2016 – tobacco businesses, beverage companies, utilities and real estate investment trusts for example – have generally seen their share prices fall in absolute terms. Meanwhile, the supposedly risky banks, retailers and more cyclical businesses have broadly seen their share prices increase in absolute terms over the same period.

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The Value Perspective team

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The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

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