Value Perspective Quarterly Letter – 2Q 2019
In this letter we answer:
- Is value investing really dead?
- Has value been disrupted?
- Can value investors profit from innovative tech companies?
- What does interest rates being ‘lower for longer ‘mean for value?
- Do rates need to rise for value to recover?
- Do price/earnings multiples still matter?
At times of market exuberance it pays to be a pessimist
“The four most dangerous words in investing are: This time it’s different.”
This is surely the most famous quote from legendary investor Sir John Templeton. The frequency with which these four words are used in financial circles serves as an anecdotal indicator of where we might be in the market cycle. If you hear them once or twice, we are probably OK, but when they are in widespread use investors would do well to take caution.
Early mutterings of ‘This time it’s different’ have developed into a cacophony, with many high profile growth managers saying that this time it really is different: that traditional valuation metrics are no longer relevant and growth can continue to outperform value in perpetuity. In short, the criticism is that us old-fashioned value investors just don’t get it.
Before we get drawn into the detail, consider this: economic and market cycles exist because of human behavioural biases. Favourable developments make people feel more comfortable. This feeling of comfort leads to risk-taking behaviour premised on optimistic assumptions. In markets, behaviours synonymous with comfort are increased use of leverage and overlooking (consciously or otherwise) or mis-appraising risk in the belief that the future will be as benign as the recent past. This is often called the paradox of tranquillity: the benign environment triggers two actions (leverage and additional risk taking), which themselves create instability.
‘Growth investing’ has outperformed ‘value investing’ for so long now, some are beginning to wonder if it will ever end. One prospective client asked us:
Could we now be in a period where growth will outperform for the next 100 years? Value has outperformed for most of the last 100 years why is it not feasible that growth does the same?
To answer this question, we should start with what value investing actually is and what it requires to work.
Value investing is the purchase of shares in companies where the market price is below its intrinsic value, and then holding those shares until mean reversion occurs and selling the shares at a higher price.
To get undervalued companies, you need an economic cycle and you need investors to get either excited or fearful to amplify the effects of that cycle.
Capitalism and the economic cycle go hand-in-hand. Capitalism ensures that when companies are making losses, capacity will exit an industry, and that when companies are making super normal profits, capital will enter the industry. Even the greatest of moat businesses such as beer and razor blades are now finding their super normal profits under pressure by new start-ups. Conversely, no new capital is launching a regional newspaper.
While this economic cycle is more extended than most, we don’t think anyone currently believes that economic cycles should be spoken about in the past tense.
We would also venture that human emotions have not fundamentally changed since the financial crisis. Humans are inherently human, and they will also be driven by fear and greed when it comes to the stock market. Companies tend to become undervalued because of a perception that their prospects have weakened in some way.
Mean reversion suggests that growth rates eventually revert towards their long-term mean or average levels. The expression ‘No tree grows to the sky’ is the colloquial phrase that embodies that mathematical truth.
A growth rate of 20% per annum eventually slows, as a business with £100 million turnover will have more opportunities to grow by 20% per annum than a business with £100 billion turnover. In this sense, reversion to the mean is simply financial gravity. Reversion to the mean will happen to any growth rate, for any business, whether we’re talking about sales or profits. For investors, mean reverting growth rates result in prospects for all businesses converging back towards the mean; this has the corollary of also pushing valuations back towards the mean.
Capitalism, and the economic cycle, accentuates the purely mathematical impact of mean reversion. While capitalism is alive, the economic cycle and value investing cannot be dead.
It is easy to be fooled by those four words; This time it’s different. Even Sir John Templeton conceded that when people say things are different, 20% of the time they are right.
Critics of value investing argue that, since the technological innovation that is often associated with growth stocks is essential in today’s world, companies without it are unlikely to be the top performers in the future. It’s certainly true the older businesses are less likely to be the fast growers of the future, but this overlooks an absolutely crucial distinction between good companies and good investments.
For example, is UK supermarket Tesco being disrupted? It certainly is, but this didn’t stop the shares going from £1.40 to £2.60. Disruption may stop the shares getting back up to £5, but as long as you don’t expect that to happen, which we don’t, you won’t be disappointed, and you have still made an 85% return.
The broader point in the frothy markets that we are experiencing today is that companies with better technology, higher potential future earnings and the ability to disrupt incumbents do not justify unbounded valuations. They can be very successful businesses while simultaneously being very dangerous investments.
The world is always changing, but that hasn’t stopped value outperforming for past 150 years.
Value investors can and do benefit from new and innovative technology businesses, but only when they are offered to us at attractive prices (such as Microsoft in 2013 – click link to see blog). To say value investors cannot benefit from innovation is to view the world through a very short-term lens.
Just as a good business is very different to a good investment, a low price is very different from good value. If, however, you are patient, do your analysis and only buy into undervalued businesses with strong balance sheets, limited amounts of debt and a suitable ‘margin of safety’, then – no matter what value’s detractors say – you will give yourself a good chance of outperformance.
The stocks of companies that are changing the world, irrespective of their prospects of profitability, tend to outperform in times of optimism as the market pays up for that potential. Value stocks – businesses with tangible value today – are likely to hold up better in less ebullient times because they are out-of-favour and therefore attractively valued, and these valuations are based on conservative scepticism rather than hope and faith.
Below, we will address some typical questions that are being asked by clients at the moment:
‘Lower for longer’ has been another rallying cry for this bull market cycle. If interest rates remain low economic growth is encouraged, defaults are scarce, financing is easy and risk-taking is encouraged. Signs of this can be seen today in many areas, from rising leverage in Private Equity buyouts, to rising overall debt levels and the growing popularity of so- ‘covenant-lite’ loans.
The chart below shows that the share of private equity deals with multiples of greater than seven times EBITDA has risen to almost 40% of the total:
‘Lower for longer’ is even being overtaken by ‘lower forever’. Today, bond investors are prepared to give Austria money for the next 100 years for a nominal yield of 1%.
What very low interest rates have done is elongate this cycle. They have enabled businesses to stay afloat when they should have exited an industry. They have allowed start-ups to get funding at rates that enable the company to be economic, when higher rates would have revealed the business model to be unsustainable. So low rates have slowed the impact of the feedback mechanism of capitalism, but they have not negated the economic cycle entirely.
Unless you believe that the economic cycle no longer exists, that human emotion has changed, that we are in a post-capitalist society and that financial gravity of mean reversion has somehow been altered, value investing will remain a feature of the investing landscape.
Value’s recovery is not binary and based on rates rising or falling. The experience of value’s outperformance in Japan during a long period of low interest rates highlights this.
If not rates then what else? We cannot know this, only offer what it might be.
Today, corporate earnings are not actually falling, but if forecasts are falling then that might be the catalyst for the market to focus on debt. At which point, those over-leveraged companies will quickly look very risky. Of course, highly leveraged companies with the highest earnings-per-share (EPS) growth forecasts have the furthest to fall.
Just as stocks priced for perfection eventually disappoint, stocks trading at a discount to the fundamental value of their underlying businesses are unlikely to maintain that discount forever.
It is important to note that value is not particularly cheap in absolute terms (it is just below the long-term average), but growth is very expensive indeed. For your equities exposure, value looks extraordinarily cheap and represents the greatest opportunity for investors today.
What is a P/E?
It’s not a number that is given to a company like its ticker or its logo, it is simply the price divided by the earnings. However, it may be more useful if instead we divide the earnings into the price, to give us an earnings yield, which is analogous in some ways to a bond yield.
So if buying a company with a P/E of 10, you are buying a company with an earnings yield of 10%.If buying a company with a P/E of 30x, you are buying a company with an earnings yield of C.3%.
There is nothing old fashioned about wanting to make 10% rather than 3%.
If put in those terms, I think many investors would think twice about buying the 3% yielder over the 10% yielder. However, more often than not, that is the decision they are making today. That sacrifice (10-3=7% p.a.) may be justified by the 3% growing faster. But the growth required for the 3% earnings yield to grow to 10% is enormous. And remember that as a company becomes bigger, that growth becomes harder and harder. That’s why no tree grows to the sky irrespective of how fast they start growing. And that’s also why valuation is financial gravity for stock markets.
This is why we believe Q4 2018 was not an aberration, but a warning. It was a warning to those that are overloaded with overvalued stocks.
When the day comes, and it will at some point, having some diversification, some exposure to a valuation-based approach will help protect investors from losses as financial gravity reasserts itself.
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.
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