Quarterly letters

Value Perspective Quarterly Letter – 4Q 2019

Value policy

31/12/2019

The Value Perspective team

2019 topped a stellar decade for equity markets, and a difficult one for value investors

No matter how you cut it, 2019 was a stellar year for equity markets. MSCI World delivered a total return of 28% in US dollar terms, which was the joint second best annual return in the last 30 years (behind only 2013).  MSCI Europe was up 23% and the FTSE All-Share was a relative laggard up by a mere 20%.

Looking at 2018 and 2019 together, only two major asset classes generated double-digit average annual returns over the two year period: US equities and global growth stocks. This continued the two most persistent equity trends of the past decade.

The absence of earnings growth in 2019 means valuations are now even higher

The MSCI World’s total return of over 28% in 2019 is an arresting figure, but what is worrying is almost all of the return came from price / earnings (P/E) multiple expansion. The decade ended with the index trading at 17x forward earnings per share (EPS), close to its highest forward valuation outside of the tech bubble. What all this means is, on a global basis, 2019’s equity rally occurred absent any growth in profits. It was driven almost entirely by higher equity valuations.

As the US gets more expensive …

While it is the nominal index level that makes headlines, this is far less important than the market’s valuation. The cyclically adjusted 10-year price-earnings ratio (CAPE) in the US currently stands at 32x. Its (very) long-term average is 17x (the data goes back to 1881).

A CAPE of 32x today puts the US equity market valuation on a par with its level at the market high before the Great Crash of 1929. In fact, it has only exceeded its level today once before; during the dotcom bubble, when it reached an all-time high of 44x.

… there are more opportunities in the UK and Europe

In aggregate, on the basis of relative valuations, the UK and Europe are attractive. Although above long-term averages, valuations are less stretched.

Twenty years of earnings growth means that despite today’s index level being higher, valuations are not as overextended as they were in the dot-com bubble of 2000.

Using the UK as an example: at the year 2000 peak, the FTSE All-Share traded on a CAPE ratio of 28x, by the 2007 peak its CAPE was 22x, whereas today, despite the higher index level, its CAPE is 16x. This is above the 80-year (UK stock market data goes back to 1927) average of 11.4x. History suggests that, from today’s valuation level, the UK stock market will deliver inflation plus 3-4% per annum for equity investors over the next decade. This compares to inflation plus 7-8% over the very long term.

Extract the value premium to improve investment returns

It is crucial to point out that a market valuation is a simple average of the individual stocks within it, and within all markets globally there are stocks that remain attractively valued. 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.

Value vs. growth: Spreads matter

Valuation spreads between value and growth are extreme. This continues a near decade-long stretch in which expensive stocks in sought-after sectors have done better than cheaper stocks in less exciting corners of the market.

There will always be a debate between value and growth investing. It happens to be the case today that the trade-off between the two approaches is starker now than at any point since the tech bubble of 2000, and on some metrics it is even more extreme now than it was then.

We can’t say how long this great growth rally will continue. We believe, however, that the best predictor of future returns isn’t what did the best over the last decade. Rather, investors should focus on today’s prices: buying assets that are cheap relative to history and avoiding things that have become expensive.

The elastic band has stretched further

The metaphorical elastic band, which stretches between market valuations and their long-term average, and also between value stocks and their growth counterparts, has been stretched even further. We believe the market’s eventual snap-back to its typical function as an arbitrator of value will be significant. Moreover, when higher asset prices are fuelled by debt, losses tend to be magnified.

Using value to diversify equity market exposure

In a strongly rising market, the merits of style diversification can become forgotten within investors’ equities allocations. Value investing as a style has stood up to be counted at times within the past decade, and on these occasions the benefits of style diversification are suddenly remembered again. 

Directing money towards different assets on the basis that, even if some are falling in price, others may well be rising, is a solid approach to investment – and one that should apply every bit as much to style as it does to, say, geography, company size or industry sector. If investors are not diversified by style, the return to long-term trend of value outperformance is likely to be painful.

Value investing’s major strength is a disciplined focus on buying attractively valued, out-of-favour companies at all stages in the investment cycle. We seek to apply this approach consistently as, while it will not always be in favour, over longer time periods, this investment style has generated exceptional returns.

Author

The Value Perspective team

Important Information:

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.