Rarely has the opportunity for value investors been more compelling than it is today.
This is the strong belief of every member of The Value Perspective team and an argument you are likely to be well aware of, if you have spoken to us or visited this site in recent months.
Something we in turn are keenly aware of is we were arguing something very similar six months ago, a year ago, two years ago … which begs an obvious question:
If we keep saying value investing will do very well when markets turn in its favour and markets continue on the seriously growth-oriented path they have stuck to in recent years then, you might find yourself thinking (and might even say to our faces), will value ever come back – or is it, well, dead?
Here then are four reasons we believe it will come back and value’s demise has – not for the first time – been greatly exaggerated.
1. ‘Value has not worked for ages’? Wrong
To find a good example of value investing working you only have to look back months, not years.
For example, if on 31 December 2017 you had a crystal ball that was great at predicting the wider economic future and so you knew both equity and debt would have a tough time producing positive returns over the year ahead, which market would you pick to invest in for 2018?
If you knew markets around the world would be terrible, you might, reasonably enough, opt for a defensive option, such as Switzerland, or one with lots of traditionally solid – if currently rather pricey – staple stocks, such as tobacco or branded consumer goods.
Yet the top performer in 2018 was Russia – an emerging market packed with oil and gas stocks that, it is fair to say, carries a fair degree of political risk.
In other words, in a year that went very badly for markets, value clearly still had something to say.
What is more, value worked very well as recently as the final quarter of last year – proving reassuringly defensive as markets went into reverse.
It may not have kept up with the absolute returns growth has made as markets have been storming back upwards over 2019 but, as we have argued before, that is not what value does.
2. ‘Value is irrelevant at a stock level’? Wrong
Our second point in defence of value’s continuing worth is that the strategy is as valid when looking at stocks as it is with markets.
This is an argument that has increasingly been coming under attack of late, as we saw in Profiting from tech companies, as a certain type of growth investor maintains that, while markets cannot be disrupted, stocks are being disrupted faster than ever before and so value no longer works in that context.
Yet the basic, very human mechanics of what leads value to work for markets – that investors grow greedy as prices rise and fearful as prices fall – is also what leads it to work for stocks.
Let’s take the very topical example of Tesco. Has it been disrupted? Absolutely. Yet that did not stop it rising 40% or so from £1.68 two years ago to nearer £2.40 today.
Sure, disruption may have prevented the business returning to the £3.50-plus at which the shares were trading five years ago but as long as you do not expect them to return to that level then it does not matter.
Disruption may have caused what you might call a ‘profit gap’ or an ‘upside gap’ – but it does not negate value cycles and it should not stop value investors from making good returns when value as a strategy turns.
3. ‘Value stocks are not growing’? Wrong
Another argument we are hearing a lot of these days is that, in a world where economic growth is harder to find, investors should be prepared to pay a premium for growth stocks over value ones.
The unspoken implication here is that value stocks do not grow and yet that is factually incorrect – value and growth stocks have actually seen their profits grow at exactly the same rate since 2016.
In that time, the outperformance of growth stocks over value has come about purely as a result of rerating – that is to say, they have become more expensive as their price/earnings (PE) multiple has increased.
That is a dangerous trend to extrapolate indefinitely into the future – as higher valuations create their own instability and vulnerability and stockmarket gravity brings an inflated share price back down to earth with a bump
4. ‘Valuation metrics do not matter anymore’? Wrong
Perhaps the most compelling argument why people should be very careful about writing off value as a strategy concerns the metric we just mentioned, the PE multiple.
Investors who have become obsessed with growth-oriented companies to the exclusion of all else seem increasingly anxious to dismiss this ratio as old-fashioned and irrelevant in a digital, disrupted world – but are they protesting too much?
Here on The Value Perspective, 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.
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).
Choose your valuations wisely
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.
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, here at The Value Perspective, we would suggest that argument is a stretch.
The tough markets we saw in 2018 – and particularly the last quarter of that year – were not an aberration but a warning.
They were a warning of what can happen when markets start to doubt the soaring valuations of the growth businesses they are backing are sustainable – and a warning that having some exposure to a valuation-based approach should serve to protect their portfolios when stockmarket gravity does reassert itself.