Value Perspective Quarterly Letter – 1Q 2018
A whole lot of noise
It may seem facetious for us to say that there isn’t a great deal to talk about since our last quarterly letter. In the first three months of 2018 have brought headlines such as ‘Volatility is back’! and ‘US-China Trade wars spook investors’, not to mention endless column inches devoted to the ongoing uncertainty about the implications of Brexit.
Indeed, UK equities were down 6.9% over the first quarter making it the worst one in over six years, and of the 23 developed markets the UK was the poorest performer (ranked by MSCI, past performance is not an indication of future performance).
Step away from the hubris, however, and little has changed.
Broadly speaking, the stocks and sectors that were both cheap and expensive at the end of last year remain so today. The UK stock market’s decline is not insignificant, but it should be viewed through a lens of the steep rise in markets of recent years.
Is value defensive?
Our portfolios' relative outperformance over the first quarter was characterised by not owning typical ‘bond proxy’ businesses, which performed poorly.
This should serve as a reminder that safety stems from the price you pay, and not the underlying dynamics of the businesses you buy.
There are no equities that are always safe or always risky. There are only equities that are too cheap or too expensive. A business could have the most volatile earnings stream in the world but, if you buy it at a 90% discount to fair value, you are giving yourself a very good chance of making money from that investment.
In the same way, you could identify the business that boasts the most stable earnings stream in history and yet, if you pay 10 times what it is worth, you are highly unlikely to make money. In fact you are more likely to end up losing money.
To us, that is the definition of risk and it has nothing to do with the supposed predictability and stability of an asset – only the price you pay for it.
What this means is that seemingly safe and stable businesses can become very dangerous investments as their valuations rise. It is our firm view that the downward share price moves of some of the so-called bond proxies in the first quarter were just the tip of the iceberg when it comes to the unwinding of market’s love affair with those equities.
Conversely, our portfolios are comprised of undervalued, unloved businesses, many of which have had near-death experiences in the recent past and are therefore prudently managed and well-placed to weather any market on economic disruption, whenever it may come.
The chart below shows the absolute sector performances in the first quarter, as well as each sectors Cyclically-adjusted Price to Earnings (CAPE). Broadly speaking, stocks in the most expensive sectors, such as Tobacco and Beverages, faired the worst, while stocks in cheaper sectors such as banks and basic materials faired better. Remember past performance is no guide to future performance.
Q1 2018 sector performances
Warning: When the CAPEs are high, subsequent long-term returns are typically poor. One drawback it is that CAPE is a dreadful predictor of short-term returns or of turning points in markets. For example, the US has been expensively valued on this basis for a number of years but that has not been any hindrance to it becoming ever more expensive during this cycle.
What does value mean to us?
In this letter we have decided to take the opportunity to revisit the tenets of our investment philosophy and process.
Just why are we value investors? And what does value mean to us?
All investors take value into account to some degree; it is very rare to find an investor that is willing to buy a stock at any price. However, our approach is closely tied to the traditional definitions of value investing. That means investing in the cheapest part of the market, as defined by a metric such as price-to-book or price-to-cyclically-adjusted-profits.
There’s a very good reason we follow this approach to value investing – the significant amounts of academic research into the value factor have all focused on the cheapest part of the market based on a defined valuation method. And those studies show value has worked over long timeframes and over pretty much every stock market. Of course, past performance isn't an indication of future performance.
Why does value investing continue to work?
We believe a lot of the reason is psychological. When you look at companies in the cheapest bracket in the market, there is usually a reason why they are there. There is often a problem which means they are disliked by the market.
When things go wrong, people’s natural reaction is to get scared and want to distance themselves from those companies. Psychologically, that means fear is driving the decision-making process and when people are scared and fearful, they make bad judgements and bad decisions.
By contrast, being a value investor requires having a strong analytical framework to make good decisions. That framework helps us identify companies where the problems are temporary and there is scope for earnings to recover and for the market to reappraise the quality of the business. It also helps us avoid those companies where the reverse is true.
In short, it means overcoming the emotions that contribute to poor decision-making.
How do we overcome emotions in our investment process?
Every active manager needs to have an edge to stand a chance of outperforming.
At its heart, an edge is something to distinguish between skill and luck in an investment process. We have four elements to our process which help us set emotions aside and give us our investment edge.
Firstly, there is the informational edge. For us, this is the use of data screens to ensure our focus is only on the very cheapest parts of the market.
Then, we have an analytical edge. This is the deep analysis we do for every stock we look at.
The next step is a behavioural edge which is our use of a risk and reward framework to help make good portfolio decisions.
Finally, we have our organisational edge; the storage of all the work we do which enables us to revisit companies that may become interesting at a later point in time.
Source: Schroders, March 2018.
The Schroders Value Team: we are purpose built for value
We believe that a great investment process is one with a high probability of superior outcomes over time.
Our process is focused on producing the best possible long-term results with minimum risk. High risk does not equal high return; low risk equals high return in the long run. Real investment risk is the chance of permanently losing some or all of the money that you have invested. Buying stocks at a discount to their intrinsic value greatly reduces the risk of capital loss. Overpaying for stocks, however it is justified, will ultimately destroy capital.
Value investing’s major strength is the disciplined focus on buying out-of-favour companies at all stages of the investment cycle. Only by being disciplined and consistent can we deliver its historically proven long-term performance advantage.
Moreover, given a history of relatively long value cycles, your investment in a true deep-value portfolio could deliver significant outperformance on a 10-year view. Of course, though, no one can predict the future and past performance is not an indication of how it might do in future.
The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, 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.
This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.