This time last year, we took a look in the rear-view mirror and admitted 2015 had been an ‘annus horribilis’ for value investors. As for whether value would recover in the year ahead, we certainly hoped it would but stressed there were no guarantees. It is why we always tell people to invest on a minimum timescale of three, or ideally five years. Caveat made, let’s again check that rear-view mirror and see how value did in 2016.
Very nicely, as it happens. Over the calendar year, the MSCI World Value index returned 13.23% in US dollar terms, compared with 3.21% from the MSCI World Growth index and 8.15% from the broader MSCI World index. We are not going to get carried away though – mainly because the corresponding numbers for 2015 were -4.11%, 3.5% and -0.32%. This pattern of performance is typical of a value style and, while long-term returns are extremely positive, this lumpiness keeps us continually humble.
The major strength of value investing, as we explained this time last year, 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 the value investment style has generated exceptional returns.
It is important to remember, however, that we will never catch the low. Sensible value investors will always sell too early when market enthusiasm turns to euphoria and buy too early when stocks fall out of favour. That said, slowly building positions on the way down and slowly exiting them on the way up should help deliver superior returns while lowering our average risk exposure.
We have noticed some investors complaining much of what they saw in markets in 2016 did not appear to be grounded in ‘fundamentals’ – the catch-all term for a range of both broad economic and company-specific factors that can influence markets. We are prepared to accept this analysis – but only because ‘fundamentals’ are open to interpretation and therefore any investor’s reading of them is not fact or truth, merely opinion.
As it happens, much of what we saw in 2016 made us positive about a return to ‘fundamentals’ because, in the end, there is only one that matters – and that, of course, is valuation. Successful investment is not about whether or not a company is ‘safe’ or even about whether or not you are convinced it has a winning business model. It is about whether or not it is cheap. Successful investment is all about the price you pay.
So while some might take the view, for example, the recovery in the oil & gas and mining sectors has gone well beyond what ‘fundamentals’ would justify – pointing to factors such as structural oversupply and a poor outlook for global demand – as we said in Looking closely, we took the view commodities businesses (and, for the record, banks) were offering lower multiples of much lower profits on a mean-reverting basis.
Let’s take as an example Royal Dutch Shell, which saw the price of its B shares rise more than 50% in sterling terms in 2016. Perhaps this was in response to the recovery in the oil price – or perhaps the market realised profits are cyclical and unlikely to stay depressed forever and so chose to focus on cyclically-adjusted price/earnings (P/E) ratios rather than on one-year P/E ratios, which are less reflective of true value.
As investors, we could expend a lot of time and energy worrying about ‘fundamentals’ and whether they are doing what we think they should be doing – or we could go where the value takes us. We will continue to pursue the latter path – and if you want to know where value investors currently are on that path, take a look at the following ‘map’ which illustrates the degree value has underperformed growth in recent years.
Past performance is not a guide to future performance and may not be repeated.
Looking back at 2016, we were positive about the way some significantly undervalued sectors were re-rated. But 2016 is history and on 2017 we have no great opinion either way – again, because we do not know what will happen over 12 months. Where we do feel confident, however, is that, over the longer term and after what, as you can see, represents only a small-tick-up in a very long period of underperformance, value looks well set.