Value investing’s underperformance over the past decade has inevitably prompted concerns that value has experienced an existential crisis. However, outside the industries directly impacted by the global pandemic, the widespread de-rating of many out-of-favour stocks during 2020 does not seem justified and we fully expect it to be reversed in due course.
Best returns usually come from cheap, high quality stocks
It is not unusual to pay a premium at times for higher quality or faster growing companies. Over the longer term though, the best returns have been generated by cheap and higher quality companies.
We define a value (cheap) company based on multiple metrics, including earnings, cashflows, and quality adjusted dividend yield. Quality is a composite of profitability, stability, financial strength, expected growth and superior governance.
Since 2017, cheap and high-quality companies have been left behind, while the best performing stocks have almost exclusively been at the expensive end of the spectrum. The increasingly disruptive nature of technological change has clearly been a key driver of market performance with a “fear of missing out” mentality benefitting a handful of well-known stocks. But how long can this last?
Are cheaper companies structurally impaired?
The strongest argument against the return of value is that the business models of cheaper companies are structurally impaired, thereby justifying their deep discount. We would agree that it definitely pays to be selective in order to weed out the stocks that are “cheap for a reason”, hence the strong integration of quality in our investment process.
However, outside the longer-term losers from the pandemic and sectors facing cyclical headwinds, such as banks and energy companies, we find little evidence that the earnings’ prospects of cheaper companies have deteriorated.
We argue that the neglect of value is the other side of the market’s fixation on a small group of winning stocks, rather than any structural impairment in value stocks themselves. This has led to low market breadth and a level of index concentration not observed in several decades.
At present, the broad-based neglect of value means that there are now plenty of high quality but very affordable opportunities across most sectors and regions. These include many traditionally defensive areas such as telecoms, health care and some consumer staples.
The strongest argument for why value tends to outperform growth over the long run is that investors ultimately overpay for growth. This seems even more true today. However, there is a growing consensus that a sustained market rotation is on the horizon following the recent good news on Covid-19 vaccines. We believe that this rotation will lead to a broadening in market participation away from the expensive mega-cap stocks as investors realise the neglected value in high quality companies, setting them up for a long-overdue re-rating.
We continue to caution that successfully investing in value depends greatly on effective implementation and good stock selection. A focus on quality is critical. We believe that a diversified all-cap approach, while avoiding the areas of low-quality value, will be key going forward.
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