Value Perspective Quarterly Letter – 1Q 2019
The industry convention of writing a new and exciting outlook every three months is one that has always left us feeling a little uneasy. Here on the Global Value team, we look out over three to five years rather than quarter-to-quarter. After all, value investing is about looking past the short-term market noise and uncovering the true fundamental worth of companies.
We are also a team that ‘doesn’t do macroeconomics’, which can make coming up with a quarterly outlook commentary a little tricky. However, while we spend our days analysing companies’ risks and potential rewards, their balance sheets and above all their valuations, we do not operate in vacuum. There are plenty of pretty scary things going on in markets today and, while we do make economic forecasts, our clients’ fears are our fears and we do all that we can to mitigate risks by ensuring the companies that we own are well-prepared to weather a wide range of future economic outcomes.
One of the scariest questions of all at the moment, for investors in all markets, is whether the US economy is heading for a recession after a protracted expansion and one of the longest bull-market runs in history. The US yield curve inverted in March (again, macroeconomics is not our forte and we suggest treating any timing indicator with extreme caution), which has a very good track-record of indicating a US recession is on the horizon.
So let us suppose that there are tougher economic times ahead, and with it, significantly more market stress. How might value perform in such an environment?
Looking back through history, how has value performed in times of market stress?
There is a conventional narrative about value, which says value stocks tend to rebound in early phases of an economic cycle, with the upsurge in prospective growth, while they stay depressed through economic downturns.
Sure enough during the opening stages of the great financial crisis in late 2007 and into 2008, a value strategy indicated a high weighting towards banks and other financial stocks. As a result, value investors had a terrible time.
Understandably, that experience will still loom large in many investor’s memories – and yet, over longer timeframes, it actually stands out more as an anomaly. You only need to look back to the most recent bouts of market stress – in February, October and December 2018 – for instances of value holding up very well as wider markets fell.
Looking at value as a style, Societe Generale have done some very interesting analysis that we would like to highlight here.
The chart compares Global Value performance to the S&P 500 in specific periods of market stress over the last 28 years (defined as when the S&P 500 underwent a correction of more than 10%). We can clearly see that across the 12 occasions, relative to wider markets, value has held up well, delivering a stronger performance than the broader market.
Source: Societe Generale
When we look back even further, using price-to-book data, which is typically used as a proxy for value performance in general, a similar pattern emerges. The value factor data assembled by US academics Eugene Fama and Kenneth French, which dates back 90 years and throws up 25 periods of market distress.
Source: Societe Generale
Over these periods value’s absolute return performance is mixed, including 11 negative returns and 10 strong rallies, but importantly value rallies are stronger than the worst value downturns. Moreover, the impact of these systemic market events was significantly lower on the average performance of the value strategy compared with the impact they had on the wider market. The implications of this analysis is that, as a style, value has performed well, or at least stayed put, on average, when broad markets have gone through significant distress. Of course, you should keep in mind that past performance isn't a guide to future performance and may not be repeated.
Stocks in traditionally defensive sectors may not be defensive investments
In equities, typical defensive sectors include consumer staples or healthcare where earnings may be more resilient in downturns. The problem comes when so-called defensive companies are over-levered and over-priced, because then they are very unlikely to be defensive investments in times of stress. Just look at the share price declines in “bond proxy” type businesses in 2018. Safety ultimately stems from the price you pay.
The defensive qualities of cheap businesses are often overlooked
Value investments are often businesses that, having had one near-death experience, are doing their utmost to avoid having another. Such companies are prudently managed, with solid balance sheets and limited debt levels, and are therefore well prepared to weather whatever the future has in store.
Instead of relying on subjective forecasts, we base our investment decisions on long-term historical data and robust processes in order to determine instances where the upside potential exceeds the downside risk. We have deliberately removed ourselves from the behavioural biases that may affect other investors by never outsourcing fundamental analysis and by sticking to a genuine 3-5 year investment horizon.
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. 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 long-term performance advantage.
The Value Perspective team
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.
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.