Value investing is neglected, not broken
The broad-based neglect of value is the other side of the market’s fixation on a small group of winning stocks.
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Value investing’s underperformance over the past decade has inevitably prompted concerns that value has experienced an existential crisis. However, outside the industries directly impacted by the global pandemic, the widespread de-rating of many out-of-favour stocks during 2020 does not seem justified and we fully expect it to be reversed in due course.
Ultimately, investing is a balance between tolerating drawdowns while maximising long-run returns. The odds today are far better for a return to favour of the long list of fundamentally attractive companies that have been neglected in recent years.
Best returns usually come from cheap, high quality stocks
It is not unusual to pay a premium at times for higher quality or faster growing companies. Over the longer term though, the best returns have been generated by cheap and higher quality companies. In the QEP team we define a value (cheap) company based on multiple metrics including earnings, cashflows, and quality adjusted dividend yield. Quality is a composite of profitability, stability, financial strength, expected growth and superior governance.
Since 2017, cheap and high quality companies have been left behind, while the best performing stocks have almost exclusively been at the expensive end of the spectrum. This is very unusual by historical standards and has never been sustained for an extended period. The global pandemic has been a further shot in the arm to expensive stocks this year, as we have seen in the momentum behind online winners alongside other longer-term thematic stocks.
The increasingly disruptive nature of technological change has clearly been a key driver of market performance with a “fear of missing out” mentality benefitting a handful of well-known stocks. But how long can this last?
Can today’s ‘glamour’ stocks justify their valuations?
The dominance of momentum in recent years means it is easy to forget that successful long-term investing is less about picking winning companies than about identifying the prices paid for those companies.
The five largest US stocks collectively trade at 31x 2021 earnings per share, a 70% premium to the remainder of the index. Both their absolute level of valuation and their premium to the rest of the S&P 500 stands at the highest level on record except for during the tech bubble.
The oft-cited justification for this is the superior profitability and growth of these stocks but the real question is how much of this has already been discounted. In our view, the expectations built into the lofty premiums associated with today’s glamour stocks are very unlikely to be realised.
To be clear, these stocks have managed to sustain strong growth for an extended period and look set to remain significant components of the key global indices for some time. However, their strong growth is already in the price. Their continued outperformance would require them to consistently beat current analyst expectations by a significant margin for yet another decade.
Are cheaper companies structurally impaired?
The strongest argument against the return of value is that the business models of cheaper companies are structurally impaired, thereby justifying their deep discount. We would agree that it definitely pays to be selective in order to weed out the stocks that are “cheap for a reason”, hence the strong integration of quality in our investment process.
However, outside the longer-term losers from the pandemic and sectors facing cyclical headwinds, such as banks and energy companies, we find little evidence that the earnings’ prospects of cheaper companies have deteriorated. Using MSCI’s style indices, less than 20% of underperformance of value relative to growth since 2017 can be attributed to earnings’ weakness. The gap is accounted for by a substantial de-rating of value that we believe is largely unjustified.
We argue that the neglect of value is the other side of the market’s fixation on a small group of winning stocks, rather than any structural impairment in value stocks themselves. This has led to low market breadth and a level of index concentration not observed in several decades.
Quality is crucial to successful value investing
In the QEP team, we start from the principle that better businesses (higher quality) will perform well over the long run. We have always believed that it is critical to be selective and understand what we are buying within value. That is all the more important now given how cheap value stocks have become, creating a lot of potential opportunities but also greater potential pitfalls.
All stocks in our global investment universe are assessed across a range of valuation models, which are then balanced with an awareness of quality. The widespread neglect of cheap companies in the recent past has allowed us to be ever more selective on quality.
At present, the broad-based neglect of value means that there are now plenty of high quality but very affordable opportunities across most sectors and regions. These include many traditionally defensive areas such as telecoms, health care and some consumer staples.
Regionally, the UK market stands out as offering a broad range of stocks that have suffered due to political risk, despite the fact that many of the larger stocks are more closely aligned with overseas markets. Japanese small/mid cap is another a good space to find very attractive stocks from a valuation perspective, spread across both domestic and export names in more cyclical areas.
Conclusion
The strongest argument for why value tends to outperform growth over the long run is that investors ultimately overpay for growth. This seems even more true today. However, there is a growing consensus that a sustained market rotation is on the horizon following the recent good news on Covid-19 vaccines. We believe that this rotation will lead to a broadening in market participation away from the expensive mega-cap stocks as investors realise the neglected value in high quality companies, setting them up for a long-overdue re-rating.
We continue to caution that successfully investing in value depends greatly on effective implementation and good stock selection. A focus on quality is critical. We believe that a diversified all-cap approach, while avoiding the areas of low-quality value, will be key going forward.
At this juncture, we would advocate investing broadly and being active (avoiding concentration in the index), while balancing quality and value, particularly given the still very uncertain economic backdrop.
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