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A shot in the arm for value?

Investing is no place for extremes of emotion in either direction and a single ‘up’ day for value stocks – even one as marked as we saw on Monday – does not a recovery make

11/11/2020

Andrew Williams

Andrew Williams

Investment Director

One small jab for man, one giant leap for value? All things are possible but let’s not get too excited just yet  – as we are stressing to all those already asking us if the market’s extraordinary reaction to Monday’s news of a breakthrough in the hunt for a Covid-19 vaccine is the start of a rotation from growth stocks into value, the huge potential for which we have been foreshadowing for some time now, here on The Value Perspective.

Regular visitors to this site will be unsurprised to learn the champagne will remain on ice for a while yet – for the same reason we have managed to resist turning to anything even stronger during value’s prolonged period in the wilderness. Investing is no place for extremes of emotion in either direction and a single ‘up’ day for value stocks – even one as marked as we saw at the start of this week – does not a recovery make.

That said, we cannot let the events of Monday pass without comment – and it certainly makes a fascinating case study for keen students of investor behaviour. Taken at face value, the vaccine news triggered a huge one-day rotation from growth to value stocks. While the update on the vaccine is clearly great news, however, the extreme moves were really a reflection of market dislocation and investor positioning going into Monday.

To put it another way, as we have written in pieces such as A contrarian play within a contrarian play and Risks the market is ignoring – Valuation risk, there is a metaphorical elastic band that stretches between market valuations and their long-term average, between value stocks and their growth counterparts, and between fundamentals and valuations. And on Monday, to some degree, that band twanged back.

Growth stocks have unarguably held the whip hand over value in the decade since the global financial crisis – and, up to now, the pandemic-induced events of this year have only exacerbated that trend. Ahead of the market falls of March and April, investors had flocked to the global technology giants for their growth potential; in the months that followed, they appeared to view the same companies as ‘pandemic insurance’.

‘Work from home’ stocks

The theory seemed to run that the so-called ‘FAANG’ grouping of Facebook, Amazon, Apple, Netflix and Google, along with other ‘work from home’ stocks, were the only the businesses that could prosper during a pandemic and therefore counted as ‘defensive’. The development of an effective Covid-19 vaccine would clearly provoke a rethink on that count.

Writing on Bloomberg on Tuesday morning, market commentator John Authurs reflected: “On a great day for markets, the NYSE Fang+ index, which had been on the verge of a record, actually fell. Relative to the average stock, as represented by the equal-weighted version of the S&P 500, the FANGs’ underperformance was epic. They lagged the average stock by almost eight percentage points on the day.”

As Authurs went on to note, that was the most since the index launched a little over three years ago – and it was not just the FAANGs that had a tough day. A range of those ‘work from home’ stocks whose shares have directly benefitted from the pandemic over the last six months or so saw prices lurch in the opposite direction – for instance, HelloFresh dropped 15% on the day, Ocado fell 12% and Zoom was down 17%.

In contrast, leading world markets upwards were a host of hitherto downtrodden and unloved businesses. These did not just include members of the energy and financial sectors – even the banks got involved, with both Barclays and Standard Chartered up 16% on the day – but also a representative or two of the aviation industry, which has been all but friendless since March.

Other selected examples include energy group Centrica, which was up 12% on the day – on absolutely no company-specific news whatsoever – while even more extraordinarily, EasyJet saw its share price rise more than a third. For its part, Rolls-Royce, which we considered in some detail on The Value Perspective back in August, ended the day up 44% – its biggest ever one-day gain.

Margin of safety

The main lesson investors should take from all this, though, is not the identities of the risers and fallers so much as the importance of what Benjamin Graham, the father of value investing, called a “margin of safety”. When good news is priced into a stock, any bad news can have a disproportionately negative effect. Similarly, when you have bought a business on a cheap valuation, a little good news can go a long way.

As Monday reminded us, just as stocks that are ‘priced for perfection’ eventually disappoint, so stocks trading at a discount to their underlying intrinsic value are unlikely to stay that way forever. Value as a strategy is built on mean reversion and the belief price and value converge over time. History certainly suggests growth’s recent dominance is unusual and value should recover to outperform meaningfully over the longer term.

The trouble is, as the economist John Kenneth Galbraith so beautifully put it: “There can be few fields of human endeavour in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”

Galbraith wrote that decades before Amos Tversky and Daniel Kahneman coined the term ‘availability heuristic’ – the behavioural finance idea that human beings tend to ascribe greater significance to more recent events – and now, in what has proved a prolonged environment of abnormally low interest rates, investors have great difficulty imagining they can ever rise higher than 1%.

Just consider, though, how unlikely the current environment would appear to most investors little more than a decade ago. Hyman Minsky, another economist, once wrote “The illusion of stability of the system will, over time, create its own instability” and, here on The Value Perspective, we would certainly argue the stability many equity investors have sought, first in so-called ‘bond proxy’ stocks, later in big tech, is wholly illusory.

‘Incredible wonders of the present’

Galbraith’s “incredible wonders of the present” manifest themselves today as abundant liquidity, ultra-low interest rates and a willingness of central banks to do, literally, “whatever it takes”. As the gap between supposedly stable companies and everything else grows ever wider, so we grow ever more concerned about the former.

In equity investment, valuation always triumphs over quality because, as their valuations rise, stable businesses can become very dangerous investments. In our view, many investors are already paying too much for perceived ‘safety’ and ‘certainty’ of growth, dislocations are still extreme and the market’s eventual snap-back to its typical function as an arbiter of value should end up dwarfing what we saw on Monday.

So can Monday’s rotation into value grow into something more than a blip? Here on The Value Perspective, it goes without saying we hope so – but, equally, we know there are no guarantees. It is worth pointing out that, in value investing, there is a direct relationship between historic and future returns – indeed, the worse the short-term returns, the better the subsequent five years has proved.

At the same time, we would very much stress we are not saying value’s performance cannot again slip back in the short term – it certainly can and has done in the past. Of course, past performance – either good or bad – is not necessarily a guide to the future but, again, it is worth pointing out that value investing has displayed a consistent pattern of mean reversion for well over 100 years.

So this piece should not be taken as any sort of message on market-timing. We cannot know when – or why – the market’s long-term preference for growth might reverse decisively (or how significant Monday could ultimately prove to be). Given the scale of value’s recent underperformance, however, we continue firmly to believe its potential sustained recovery is the most attractive opportunity facing patient equity investors today.

Author

Andrew Williams

Andrew Williams

Investment Director

I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm. 

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The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.

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