Value versus growth and irrational markets
The battle between growth and value rages on. Following value’s so-called “lost decade”, there was a marked rotation towards the style in 2016. This wasn’t to last though, and value has given up much of its gains versus growth over the first six months of 2017.
Growth’s continued march north has come about courtesy of the US IT sector (driven by the so-called FANGs: Facebook, Amazon, Netflix, and Google), and consumer staples in the UK and continental Europe (driven by the so-called “bond proxies”). In the first half of 2017, the valuation gap between these racy US tech companies and sleep-easy bond proxies, and everything else has become wider. We are increasingly fearful of the former as in equity investment, valuations will always triumph over quality in the long run because as their valuations rise, stable businesses can become very dangerous investments.
Mr Market is ignoring the fundamentals
There is, however, some comfort to be found in value’s underperformance over the first half of 2017. Across the globe, the majority of the performance gap between value and growth can be accounted for by the higher price/earnings (P/E) multiples of growth stocks. In other words, investors have been willing to pay even more for those “growth” companies than in the past. An environment where P/E multiples are rapidly outstripping even the most bullish of sell-side analyst forecasts has echoes of the long build-up to the dotcom bubble in 2000. It is evidence of a classic behavioural bias where investors extrapolate current trends when forming future expectations.
This chart shows earnings-per-share growth and price performance of MSCI World Growth and MSCI World Value of the first half of 2017. While the price of growth stocks has outstripped higher EPS growth, the market has ignored EPS growth of value stocks.
Earnings-per-share growth and price performance of MSCI World Growth and MSCI World Value
While we would rather avoid periods of underperformance, there are better and worse ways to underperform the market over short time periods. The valuations of growth stocks are now pricing in ever-higher future earnings despite global profit margins nudging to all-time highs. History suggests that this cannot last forever, and in the past a market dislocation such as we are seeing now has been a precursor to value’s outperformance as expensive growth companies withdraw to lower valuations. The chart below highlights the extent of growth stock’s absolute valuation on price-to-book , which is now far higher than at the peak of the dotcom bubble in 2000.
Price to tangible book of MSCI World Growth
A word of caution
This is not a market-timing message. Performance could continue to suffer in the short term. 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. 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.
What do true deep-value investors do differently?
Despite overwhelming evidence against the veracity of predictions (including earnings forecasts), humans are hard-wired to follow them. People seek cause and effect in random patterns and extrapolate them into the future, but they are doomed to fail because the future is not a fixed outcome; it is a range of possibilities. Another closely linked behavioural bias is that investors tend to assign more weight to the most recent outcome when making future decisions, irrespective of their probability. This is why investors tend to do very silly things as bubbles grow and irrational exuberance prevails.
The investor’s chief problem – and even his worst enemy – is likely to be himself
Benjamin Graham, The Intelligent investor
The Schroders Value Team: we are purpose built for value
It is imperative to eliminate all emotion from investment; if it feels good it probably isn’t. But not knowing what the future will bring does not mean that we cannot prepare for it. Instead of relying on subjective forecasts, we base our investment decisions on long-term historical data and robust processes in order to determine instances where the upside potential exceeds the downside risk.
In fact, value is all that we do. We are a pure style-based team. We have deliberately removed ourselves from the behavioural biases that may affect other investors by never outsourcing fundamental analysis and by sticking to a genuine 3-5 year investment horizon – a rarity in a world of truncated attention spans fuelled by minute-by-minute news updates.
We believe that a great investment process is one with a high probability of superior outcomes over time. Our process is focused on producing the best possible long-term results with minimum risk. High risk does not equal high return; low risk equals high return in the long run. Real investment risk is the chance of permanently losing some or all of the money that you have invested. Buying stocks at a discount to their intrinsic value greatly reduces the risk of capital loss. Overpaying for stocks, however it is justified, will ultimately destroy capital. 130 years’ of equity market data show that, on average, the price you pay is the key determinant of whether or not you will make money with an investment.
Value investing’s major strength is the disciplined focus on buying out-of-favour companies at all stages of the investment cycle. What separates the Benjamin Grahams of this world from the average fund manager is an investment process that is repeatable, process-driven and based on history. That is value investing – and only by being disciplined and consistent can we deliver its long-term performance advantage.
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