With the value factor underperformance accelerating, and cheap stocks seemingly more unloved than they’ve been since the end of the century, Rhynhardt Roodt looks at whether Value investing is dead, or just dormant.
My name is Rhynhardt Roodt and I am a Portfolio Manager for the Investec Global Equity Strategies.
Value factor underperformance has accelerated in the last year and cheap stocks today seem to be more unloved than what they have been since the turn of the century. So is Value investing dead or simply dormant?
Let’s perhaps take a step back and ask why buying Value should theoretically pay off over time. When investing, we have a choice to make forecasts or to rely on mean reversion. But forecasting is rather difficult whereas the hit rate on mean reversion tends to be somewhat better, at least historically.
So a potential opportunity for Value stems from investing into uncertainty. When the market is projecting weakness into the future and when returns are poor, one can assume that capital will exit an industry. This causes prices to increase and helping profitability for those businesses to recover. For equity investors, the reward comes in the form of valuation multiples expanding, not necessarily from earnings growth.
So why is Value investing having such a tough time, especially within developed market equities? Let’s perhaps start by reflecting on a key topic in today’s markets, disruption. Value stocks or sectors always look challenged, which is why the anomaly of Value occurs in the first place. However, the composition of the so-called Value universe is arguably now more concentrated in sectors where perceived earnings risk is highest, either structurally or cyclically.
What is interesting, however, is that earnings growth in these Value areas have, in fact, broadly kept pace with the rest of the market, yet we do observe an increasing divergence in return metrics. We also observe higher financial leverage for cheap stocks relative to history. The quality and perceived durability of earnings growth are therefore key focus areas in today’s market for investors.
Many sectors of the economy have never been fundamentally disrupted by technology and regulation. Auto manufacturers are being disrupted by electric vehicles and autonomous driving. Traditional utilities are being disrupted by renewables. The tobacco industry is faced with the rise of vaping and intense social scrutiny, while high street retailers are losing share to Amazon and a multitude of start-up brands which market their merchandise via social media.
Indeed, many would argue that technology itself has given rise to semi-permanent winners in some industries, which, in fact, goes against the theory of mean reversion. To complicate matters further, we observe that those businesses that tend to be the disruptors have high and growing levels of intangible assets on their balance sheets. As many of these intangibles are expensed and not capitalised, one might therefore argue that traditional valuation measures based on earnings and book value might be less relevant than before.
Moving on to the cyclical market backdrop, we also know that bond yields are at all-time lows, which might also help to explain why the Value factor is underperforming. The net present valuation of Value stocks tend to be heavily skewed towards the early years, making Value a classic short-duration factor. Yet, as interest rates have fallen, we have observed that long-duration assets, those most sensitive to a change in discount rates, have benefitted the most. One could also argue that lower interest rates have resulted in excess capacity remaining within low-return businesses for longer, prolonging the prospect of mean reversion.
Lastly, some people argue that Value is being structurally arbitraged away by the rising popularity of smart-beta strategies, exchange-traded funds and high-frequency trading. This is almost a separate topic, beyond the remit of this update. However, I would point out that the very long-term pay-off profile of a factor such as Value would argue against this.
So is Value investing structurally dead or is it merely cyclically dormant? This debate will certainly rage on but, for what it is worth, we do not believe that buying overvalued assets has suddenly become a winning investment strategy overnight. However, we are aware that market structure and the companies that we invest in have evolved.
We also accept that the current broader economic backdrop is proving rather challenging for businesses that are, in fact, more economically sensitive. Most Value stocks do not fully recover and some, indeed, do go out of business. Yet some businesses will adapt and reinvent themselves, creating the potential for super-normal returns.
We will therefore concentrate our efforts on strong, bottom-up fundamental research to drive the value of our stock selections. As always, we aim to invest in those businesses that are not only attractively valued but are also of high quality, with improving operating performance and that are receiving increasing investor attention.