Missing November’s value rally does not mean missing ‘the value boat’
The huge dispersion in valuations that built up between growth and value stocks over the last decade or so means carefully-selected instances of the latter still have significant potential to outperform
Given the significant rally value has enjoyed versus growth since last November, many investors will be kicking themselves at a missed opportunity and wondering if they might have missed the boat. Given the huge dispersion in valuations that built up between these two investment styles over the last decade or so, however, it is not so much that ‘the value boat’ has already left port – it has barely even left the shipyard.
Taken as a group, equity investors undeniably face a problem: on a global basis, markets have already priced in a full recovery from the pandemic. As the following chart, produced by Minack Advisors, shows, major asset classes had a strong 2020 with double-digit percentage gains for global equities and commodities – and bonds not far behind. Some may have predicted such ebullient markets this time last year – but certainly not in the face of a global pandemic.
While there may be little trace of the pandemic in 2020’s returns at the broad asset class level, however, it remains painfully obvious everywhere else – especially in our day-to-day lives and our interactions in the real economy. Even so, markets have been confident enough to bank in a significant improvement in health and economic conditions, with the overvaluation of the US equity market one particularly well documented result.
In sharp contrast, UK equities would appear an attractive prospect for investors as the market is trading at a significant discount to major counterparts around the world. Brexit, the relatively severe impact of the pandemic on the country and the composition of the market, with its high concentration of dividend-paying mega-cap stocks, have combined to ensure the UK remains unloved.
On an absolute basis, the UK equity market – measured as the FTSE All-Share – is valued only slightly above its long-term average, which implies a 10-year return of approximately inflation plus 4% a year for equity investors. Never forget, however, that a market’s valuation is merely an average of the valuations of the individual stocks within it – and, among individual UK stocks, there are some hugely attractive opportunities.
In article such as Valuation risk, here on The Value Perspective, we have pointed out how, for much of the last decade, it has seemed as if company valuations no longer mattered to many investors. Indeed, as we will shortly see, UK value had become extremely depressed on a very long-term view with relative performance versus growth close to an all-time low on data going all the way back to 1975.
We also urged investors to bear in mind how, like an elastic band stretched to its limit, valuations can snap back very quickly indeed – and, last November, we witnessed one of the largest two-day rotations from growth to value stocks on record. Ostensibly triggered by positive vaccine news and the US election result, the extraordinary share price moves were, in essence, a reflection of just how polarised markets had become.
A range of ‘work from home’ stocks, whose shares had directly benefited from the pandemic, saw prices lurch downwards. Leading world markets in the opposite direction, meanwhile, were a host of hitherto downtrodden and unloved businesses – shares in high-street bank NatWest moved 60% higher over the last three months of 2020, for example, while those of aircraft engine-maker Rolls-Royce more than tripled.
One lesson investors should heed from all this is that, when good news is already priced into a stock, any bad news can have a disproportionately negative effect. On the other hand, when you have bought a business on a cheap valuation, a little good news can go a long way – and, as you can see from the following chart of that data going back to 1975, the recent stellar outperformance of value is evident on the far right-hand side.
The UK value vs growth average relative valuation premium at 6 January 2021
Returns in the last months of 2020 were a stark reminder stocks ‘priced for perfection’ eventually disappoint, while those trading at a discount to their underlying intrinsic value are unlikely to stay that way forever. What you will also note from this chart is how, despite the recent rebound, valuations of value versus growth remain at historical lows – and well below where they were even at the peak of the dotcom bubble in 2000.
Here on The Value Perspective, we do not profess to know when the tide will fully turn – only that this ongoing extreme polarisation, with a handful of stocks and sectors continuing to be preferred at the expense of all else, is unsustainable. For our part, our portfolios comprise companies that have both significant room to re-rate and a high probability of considerable profit recoveries. There is still time to come aboard this boat.