Value Perspective Quarterly Letter – 3Q 2018
On 22 August equity markets reached a significant milestone: the US officially recorded its longest bull market in history. The last low set by the S&P 500 Index was way back in March 2009. 3,453 days of steady growth later has resulted in a price appreciation of 320% over the period. The previous record bull run started in October 1990 and ended in March 2000 with the dot com crash. The behaviours and biases driving the US market higher and higher are certainly not constrained by borders, and we can all learn from what is happening in the US today.
What goes up must come down … eventually.
We bring up the US stockmarkets milestone not to call the top of the market, but to question the sustainability of seemingly unassailable rising prices. We believe in mean reversion, and the days of investors being happy to pay ever-increasing earnings multiples for growth companies are getting rather long in the tooth. One real cause for concern is just how concentrated the drivers of this record-breaking run have been.
The chart below shows that as this bull market has aged, the drivers of its returns have become increasingly narrow.
As developed markets came out of the recession almost a decade ago, equity market returns were fairly homogenous regardless of investment style or region. The last three years, however, could not have been more different. Growth has unequivocally trumped value, US stocks have trumped growth, and US tech stocks have left everything else in their wake.
Both Amazon and Apple’s market cap has surged past $1 trillion this year. What’s staggering is that Amazon’s share price has more than doubled in the last 12 months, adding some $520 billion in equity value in the last year alone. That increase is itself as large as the market capitalisations of the fifth and sixth most valuable public companies in the world (Berkshire Hathaway and Facebook).
Will the FAANGs lose their bite?
The question that we ask ourselves is, just how likely is it that the next five years will be similar to the last five?
We steer well clear of predicting the future but let us just consider one possible scenario: that the FAANG stocks (that’s Facebook, Apple, Amazon, Netflix, and Google) continue along their current trajectory. That is a crude extrapolation – no question about it – but, subconsciously or otherwise, it does reflect the sort of expectations many investors are building up. If the FAANGs see their share prices rise over the next five years to the same degree they have from 2013 to now, then by 2023, their combined market capitalisation will have grown from $3.6 trillion to some $17 trillion. That is the equivalent of one-third of the current market capitalisation of the MSCI World Index or one-fifth of the entire globe’s current gross domestic product. We are not saying it cannot possibly happen but thought about in those terms, history suggests this level of growth is very unlikely (past perormance is, of course, not a guide to future performance and may or may not be repeated).
As 2018 has unfolded the valuation gap between those racy US tech companies and everything else has become wider. We are increasingly fearful of the former as an equity investment. Valuations will always triumph over quality in the long run because as their valuations rise, great businesses can become very dangerous investments. There will, however, be periods where the market’s role of an arbiter of true value may lie dormant, and, as is evident today, these may be prolonged.
The danger results from confusing perceived safety with received safety. A metaphor proposed by the philosophical statistician Nassim Taleb brings this to life eloquently:
Consider a Thanksgiving turkey is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief…Consider that the feeling of safety reached its maximum when the risk was at the highest!
We are not forecasting that these tech stocks will be slaughtered tomorrow, but we urge investors to be very wary of extrapolating recent growth well into the future.
Mark Twain most famously said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”. In that spirit, we deem it is necessary to consistently check and challenge both ourselves and the consensus.
It is our core belief that repeatable long-term returns can only be achieved through buying businesses for a price lower than their intrinsic value - the so-called “margin of safety” that as value investors we seek so resolutely.
What about the UK market?
In aggregate, the UK market is not as expensive as the US, but nine years into a bull market, it is no longer cheap. And as we alluded to above, the same animal spirits at work in the US equity market are at work in the UK as well. What is crucial to point out, however, is that the overall market valuation, be it that of the US or the UK, is a simple average of the individual stocks within it and within those stocks there remain some attractive opportunities.
It is these opportunities that give us confidence in our ability to continue to extract the c.2% premium return offered to value investors over and above the market itself, through focusing investment in the cheapest parts of the market. Relative to other funds which are overly-exposed to expensive companies, our portfolio’s outperformance should be significant.
History suggests that many investors will come to regret the high price they paid for tech giants or bond proxies (stocks which have the yield characteristics of bonds). The reason they will regret it is these stocks do not have an adequate ‘margin of safety’.
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. 130 years of equity market data shows that, on average, the price you pay is the key determinant of whether or not you will make money with an investment.
The securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.
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.