Value Perspective Quarterly Letter – 4Q 2015
2015 was an annus horribilis for value investors. As an investment style, value has underperformed growth for the longest period on record (see chart 1) and is currently trading at the widest discount to growth since the dot-com bubble in 2000. 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; a trend that has accelerated over the past 12-months.
Chart 1: Ten- year annualised relative return
Why has this happened?
In an uncertain world, people crave stability. The combined efforts of the world’s central banks have created an unparalleled environment of ultra-low interest rates and ubiquitous liquidity, a corollary of which has been investors’ willingness to pay up for growth or ‘stable’ earnings. The result is an equity market that has become highly polarised. Conventional wisdom has accepted the current environment of lacklustre economic growth as “normal”. The market has therefore ascribed a considerable scarcity premium to businesses that have either demonstrated or prospective near-term growth prospects. As value investors, we care far more about the price we pay for future earnings and far less about the rate of expected earnings growth.
Will this last forever?
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 as a strategy is built on mean reversion and we believe that price and value converge over time. Indeed, history suggests the status quo is unusual and that value will recover and outperform meaningfully over the long term.
“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."
- John Kenneth Galbraith
Long before the term “availability heuristic” was coined by Amos Tversky and Daniel Kahneman in the 1970s, John Kenneth Galbraith was certainly onto something. In today’s environment of prolonged and abnormally low interest rates, investors have difficulty imagining that interest rates can ever be more than 1%, but consider just how unlikely the current environment would appear to most investors only a decade ago. As the economist Hyman Minsky put it, “the illusion of stability of the system will, over time, create its own instability”. It is our view that the stability many equity investors have sought in so-called ‘bond proxies’ is illusory.
Galbraith’s “incredible wonders of the present” manifest themselves today as abundant liquidity, ultra-low interest rates and central banks’ willingness to do, literally, “whatever it takes” (often despite the potential negative longer-term consequences of their actions). 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 growth. 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.
Will value recover in 2016?
We certainly hope so, but there are no guarantees. If we look at the portfolios that we manage there has been a direct relationship between historic and future returns – the worse the short-term returns, the better the subsequent five years has been. What we are NOT saying, is that performance can’t get worse in the short term – it certainly can and has done in the past. Past performance is not necessarily a guide to future performance. However, value investing has displayed a consistent pattern of mean reversion over more than 100 years. This is not a market-timing message. We cannot know when the current trend will reverse, or the catalyst, but, given the scale of value’s underperformance, we believe that its potential recovery is the most attractive investment opportunity for patient investors in today’s equity markets.
Finally, it is important to remember that we will never catch the low. Sensible value investors will always sell too early when enthusiasm turns to euphoria and buy too early when stocks fall out of favour. However, through slowly building positions on the way down and slowly exiting them on the way up, we may deliver superior returns for our clients as well as 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. We seek to apply this approach consistently as, while it will not always be in favour, over longer time periods, this investment style has generated exceptional returns.
The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams and Andrew Evans, members of the Schroder UK Specialist Value 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.
This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.