Value Perspective Quarterly Letter – 3Q 2016
The UK equity market is approaching all-time highs. What does that mean for future returns?
The FTSE 250 has recently reached a record high. The FTSE 100 has broken the 7000 point barrier and is fast approaching its year 2000 and 2007 peaks… peaks that were followed by the ‘dot-com bust’ in 2001 and the ‘credit crunch’ of 2008.
But the nominal index level is far less important than its valuation. Sixteen years of earnings growth mean that, despite today’s index level, valuations are not as overextended as they were in the past. At the year 2000 peak, the FTSE 100 traded on a cyclically adjusted 10-year PE (CAPE) ratio of 27.1x, by the 2007 peak its CAPE was 20.5x, whereas today, despite the similar index level, its CAPE is 15.2x. The broader UK equity market, measured as the FTSE All-Share, is valued above its long-term average but not egregiously so, implying a 10-year return of approximately inflation +4% per annum for equity investors.
UK Market: Show me the value
It is critical to point out that the market valuation is a simple average of the valuations of the individual stocks within it, but among those stocks there are some exceptionally attractive opportunities. Let’s first consider size groupings. The FTSE 250 trades on a CAPE of 25.9x while the FTSE 100 trades on a CAPE of 15.2x. Sometimes deep value can be found in plain sight. The cheapest sectors in the UK today, banks and basic materials, contain some of the largest stocks in the UK equity market.
A related phenomenon is valuation spreads, which measure the valuation difference between cheap stocks and the market average. Data from equity markets around the globe show that valuation spreads today are wide relative to history, thereby presenting an attractive opportunity for value investors. In the past, periods of wide spreads have been characterised by investors all facing the same way and ignoring one set of stocks in favour of another. The dot-com bubble is a prime example. The stock market darlings have changed, but the market’s myopic focus is a clear parallel between early 2000 and today. History doesn’t repeat itself but it often rhymes.
In the UK, while valuation spreads are very high between sectors they are very narrow within them. This means that all stocks within unloved sectors have been tarred with the same brush, irrespective of their individual characteristics. It is at times such as these that the benefits of active stock picking come to the fore, as those investors willing to do the work are able to find companies within those unloved sectors with sufficient balance sheet strength that trade at very attractive prices. It is these opportunities that give us confidence in our ability to continue to extract the circa 2% per annum premium return that has been historically offered to value investors over and above the market itself, through focusing investment in the cheapest parts of the market.
Everyone wants yield, but at what cost?
The disparity in valuations between the cheapest and most expensive parts of the global equity market is extreme. As we would expect, in the most expensive part of the market we find stocks that are growing rapidly (parts of technology for example) but there are also food & beverages and tobacco companies. Such areas are more associated with stability of earnings than with growth, and the premium paid by investors for the perceived safety of many traditionally defensive stocks has continued to increase. As we have discussed in previous quarters, this only enhances what we might term the ‘bond proxy paradox’ – the hunt for supposedly safe and stable stocks since the credit crisis pushing up the valuations of these stocks to a point where they can really no longer be considered safe or stable. Chart 1 shows the CAPE premium of the global consumer staples and healthcare sectors relative to the global equity market.
Source: Schroders, Thomson Datastream, world indices and sectors as at 30 June 2016. Sectors shown are for illustrative purposes only and should not be viewed as a recommendation to buy or sell
The question sensible investors must ask themselves is, do valuations make sense in the absence of pure yield? With the valuations for many of these traditionally defensive businesses at all-time highs, the answer is clearly no. So called ‘bond proxies’ have become momentum stocks; re-rating significantly since the ultra low interest rate and bond yield environment was established in 2009. There is no such thing as an asset that is always safe or one that is always risky – your risk is determined by the price you pay.
Deep Value. It’s lonely out there …
Value has underperformed growth for the longest period on record and is currently trading at its widest discount to growth since the dot-com bubble in 2000. The Russell indices in the US show value has underperformed growth by 40% since mid-2006. The underperformance of value strategies compared with growth in all major markets around the globe is uncontested. To our regular readers this information will not come as a surprise. It is a phenomenon that we have commented on for over a year now, and one where in most areas (basic materials being a notable exception) the distortions within the market have become even more extreme.
This difficult decade for value has not won it many friends. Most investors have found this poor performance difficult to stomach and have abandoned value in favour of so called ‘quality-value’ growth or momentum strategies. Chart 2 shows the style bias all of the funds under management in the UK. The data, provided by Morningstar, includes all UK domiciled UK equity portfolios (427 funds) and, through analysing each portfolio’s underlying holdings, Morningstar calculates the style bias within each fund. Of almost £500 billion in assets under management, only 9% is run in a value style, and the Value Team at Schroders runs five of the six most value exposed funds in the entire market.
Source: Schroders, Morningstar Direct, based on Morningstar UK domiciled funds using fund data available July 2016, excludes funds with no value score available.
As charts 3 and 4 show, this phenomenon is echoed in Europe and globally.
Source: Schroders, Morningstar Direct. *Based on Morningstar Luxembourg domiciled. European Equity funds using fund data available July 2016, excludes funds with no value score available.
Source: Schroders, Morningstar Direct, July 2016. *Luxembourg domiciled Global Equity Funds, excludes small cap portfolios and funds with no value score available.
The consequences of value’s difficult decade are stark. As other investors have run where the performance has been, we offer an increasingly unique proposition of having the best chance of being positioned where the performance will be. Whilst this is a prediction, it is based on a consistent pattern of mean reversion demonstrated around the world for more than 100 years. The price you pay is the most important determinant of future investment returns – buying the cheapest stocks gives the best returns – and the rewards of following a value style can only be realised via its disciplined application throughout the economic cycle. History suggests that, for those investors willing to be patient, the outperformance from a true deep-value portfolio should be significant on a 10-year view.
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.