Investment Insights

Why value still matters hugely in this growth-obsessed world

Those who write off value off as an investment strategy are effectively saying investors should at no point care what return they are making on a company – and surely that cannot be the case.

12/08/2019

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Of all the arguments for why people should be very careful about writing off value as an investment strategy, perhaps the most compelling concerns the humble price/earnings (PE) ratio.

Investors who have become obsessed with growth-oriented companies to the exclusion of all else seem increasingly anxious to dismiss this metric as old-fashioned and irrelevant in a digital, disrupted world – but are they protesting too much?

We would argue the PE is something of an ‘inconvenient truth’ for investors who believe the market’s fondness for growth can continue indefinitely – that, really and truly, this time it’s different.

You see, a PE is not some label or badge you append to a company like a logo or a stockmarket ticker – no, a PE ratio is fundamental measure reached by dividing a company’s share price by its earnings.

The earnings yield

To illustrate how important that should be to any investment analysis, let’s flip the measure on its head – that is, earnings divided by share price – to reach what is known as the earnings yield, which is in some ways analogous to a bond yield.

When bond investors lend money to a company, they do so at what they believe to be the appropriate risk-adjusted rate – 2%, 3%, 4% or whatever – that will enable them to make a return.

And so it goes with shares.

In effect, equity investors are also lending money to a company and the earnings yield – through the PE ratio – tells them the rate at which they are doing so.

Thus what would generally be a cheap PE of 10x (10/1) becomes an earnings yield of 10% a year (1/10) while what would generally be an expensive PE of 30x (30/1) becomes an earnings yield of a bit over 3% a year (1/30).

What that means is an investor today could opt to lend their money to a company for a yield of 10% or 3% –  and, whether they realise it or not, plenty of investors are currently picking the latter option in the hope, belief or expectation their chosen business will grow extremely fast.

And that decision to sacrifice 7% a year might well prove justified but the growth required for the earning yield to move up from 3% to 10% is enormous.

Would you sacrifice 7% a year?

Faced with a straight choice of a 10% yield or a 3% yield, most investors would think twice about buying the latter – and yet that is exactly the choice they are making when they decide to buy growth-oriented stocks over value ones.

The bigger a company becomes, the harder it is for it to grow further – or, as the proverb goes, ‘Trees do not grow to the sky’, irrespective of how fast they start off.

And the same is true of the huge businesses so beloved of the wider market today.

They are now so large, they will struggle to sustain their growth rates – and thus to grow their earnings yield from, say, 3% to 10%.

If value truly has become irrelevant in the modern world, then investors should at no point care what return they are making on a company – and we would suggest that argument is a stretch.

More investment insights 

Read about the Schroder Global Recovery Fund.

Important Information:
This material has been issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders) for information purposes only. It is intended solely for professional investors and financial advisers and is not suitable for distribution to retail clients. The views and opinions contained herein are those of the authors as at the date of publication and are subject to change due to market and other conditions. Such views and opinions may not necessarily represent those expressed or reflected in other Schroders communications, strategies or funds. The information contained is general information only and does not take into account your objectives, financial situation or needs. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this material. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this material or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this material or any other person. This material is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any references to securities, sectors, regions and/or countries are for illustrative purposes only. You should note that past performance is not a reliable indicator of future performance. Schroders may record and monitor telephone calls for security, training and compliance purposes.