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Three new arguments against value – and why they don’t hold water

As the fortunes of value have yet to improve in the way its followers might have expected at this stage of the market cycle, it is important to keep testing the arguments of those who say the strategy no longer works

19/05/2020

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

The life of the value investor is not supposed to be an easy one – indeed, the inherent difficulty is rather the point. The last few months have, however, proved particularly frustrating because market downturns are at least supposed to hold a silver lining for value. That has not materialised – so far – so it is important to keep testing the various arguments of the strategy’s doubters that, this time, it really, really, really is different.

Here on The Value Perspective, we do not find such arguments convincing and yet there is no denying that value has yet to see the upturn in fortunes that tends to follow periods of significant market stress, such as we have experienced in recent months. The historic pattern of downturns is that, at the start, stocks sell off across the board because the market grows scared and is in no mood to distinguish between good and bad.

In due course, however, the prices of good businesses with strong balance sheets that have been overlooked by most investors tend to be the first to find a floor – at which point they gradually outperform on a relative basis. Then, as the wider market finds its own floor, those value stocks really start to kick on and outperform in both relative and absolute terms – as we saw in the wake of both the tech bubble and global financial crisis.

Soul-searching

And it felt to us – and indeed to many other market strategists – that there was no real reason this would not also prove to be the case this time around. The fact this has not yet come to pass has led to much soul-searching within the value community as to possible explanations – and, predictably enough, an avalanche of arguments that, as an investment strategy, value has ceased to be.

Such pronouncements have formed the backing track for value investing throughout its lifetime, leading us in turn to write a number of responses over the last few years, here on The Value Perspective – most recently Value investing dead? Four reasons why that just isn’t the case. Value’s health was also a key point of discussion when we talked to value investor and author Tobias Carlisle at the end of last year.

In the last couple of months, a number of new arguments have surfaced as to why value has yet to bounce back in the way its supporters might have expected. Given the importance value investors attribute to challenging conventional thinking, it is only reasonable we should continually put our own strategy under the microscope and consider the merits of any objections raised against it.

One of the new arguments against value investing is that it has been undermined by the way companies now present their accounts – in effect, that significant amounts of the value created within a business relate to ‘intangible’ aspects, such as brand recognition, goodwill and intellectual property, and modern accounting does not adequately reflect that.

Constantly evolving

Given value investors spend much of their time poring over company accounts to ascertain balance sheet strength, levels of debt and so forth, this would be a serious development – and yet corporate accountancy is constantly evolving. The way businesses present their numbers has changed throughout the history of accountancy and there are no clear gaps where value investing worked under one regime and not the next.

Over the years there have been some huge shifts in the way accounts are produced – from how pension deficits are reported to the introduction and evolution of the International Financial Reporting Standards – all of which have affected how the intangible assets of a company are assessed. This in turn will have had an impact on the business’s ‘book value’ – that is, the value of its assets minus its liabilities.

Granted, these may all seem pretty esoteric distinctions and yet, if the primary thrust of your argument is that only now does accounting stop you truly calculating the value of a business, what is the cliff-edge difference from where it did at a previous point? Equally, is there any step-change you can identify in the performance of value strategies that would indicate that was indeed the determining factor? We would argue none exists.

What is more, even if you could identify such watershed moments, it would not matter because you do not have to use a price-to-book ratio to calculate a business’s value. You could use metrics where the measurement of intangibles has less impact – for example, cashflow, dividend yield or enterprise value to sales – or indeed more esoteric measures explicitly designed to include intangibles.

No matter which method you pick, however, they would all agree on two important points – first, value has worked over time; and second, irrespective of how it is defined, value has not performed recently. If these facts hold true whether we adjust for intangibles or not, the impact of intangibles on book value or profits cannot be the explanatory factor for value’s recent underperformance.

‘Winner takes all’

Another argument we are seeing more of these days is that we are operating in a ‘winner takes all’ economy – and, since global technology stocks are the winners, the US market is going to carry on upwards, regardless of valuations. That argument might have some validity if it were only tech stocks that were driving this ‘value versus growth’ distinction – and only in the US – but that is simply not the case.

Neither the UK nor Europe boasts any global tech stocks to speak of and yet value is underperforming there – and the same holds true for the emerging markets, which have only a few global tech players between them. Value’s underperformance is not reliant on a group of companies or on a sector – making this particular argument less a logical analysis than an after-the-fact rationalisation of what has been happening.

Of all the recent cases we have heard for value’s underperformance, perhaps the oddest is that what made the style successful in the past has now been arbitraged away. Yet for something to be arbitraged away, more and more people need to be doing it and, given value’s recent showing, the precise opposite seems more likely. Certainly, from our own perspective, very few people are following true valuation-based strategies these days.

Suggesting ‘value no longer works because everybody does it’ is reminiscent of the old Yogi Berra line that ‘nobody goes to that restaurant any more – it’s too crowded’. The stark reality is virtually nobody is now doing value because its performance has been so bad. Yet, at the same time, that is why the strategy ultimately works – because there are no guarantees and there needs to be some pain before there is any reward.

This is the pain

And this is the pain – oh boy, is this the pain. We are keenly aware of this – as we are of the fact that our investors will hurting too. As we explained in Countering the despair of volatile markets, however, before markets can head upwards once more, investors need to work through the stages of panic, despair and, finally, capitulation – the point of maximum hurt when almost everyone throws in the towel and sells up.

So when will the market turn in value’s favour? We do not know the answer to that question – and nor does anybody else. What we do know is that, like us, nobody – not our competitors, not investment strategists or asset allocators, not the more thoughtful academics or market commentators – has managed to come up with a good reason why things have not turned yet.

Everyone has been left scratching their heads – especially given how, as we have explained in pieces such as Time to brave, the relationship between value and growth is more distorted now than at almost any time in stockmarket history. As we said, though, value offers no guarantees and not even the extreme nature of the current market means anything is going to change in the short term.

All things considered, then, it is prudent to revisit and review all the assumptions we make – as well as to test every argument being put forward as to why value might no longer be effective as an investment strategy. We can see no real merit in any of the arguments made thus far and, as such, remain confident value will reward – on average and over the longer term – those who patiently adhere to the disciplines it demands of us.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Important Information:

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.

They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

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