How low interest rates and big tech are making value investing a nightmare

The challenge is to do enough homework to make right picks, Martin Pelletier writes.

One of my roles as a chief investment officer for family offices and institutional clients is to review outside managers and to ensure they are delivering on expectations. Surprisingly, despite today’s strong equity market, we’ve noticed that quite a few managers are underperforming, either due to their inability to generate alpha by poor stock picking and/ or because their style of investing has been out of favour.

One strategy in particular that stands out as a serious laggard is value investing, which involves picking stocks that appear to be trading for less than their intrinsic or book value.

Here in Canada, value stocks as represented by the Dow Jones Canada Select Value Index have underperformed the S&P/TSX by 6.1 per cent in the past year and an annualized 1.7 per cent over the past five years. In the U.S., the S&P 500 Value Index has underperformed the S&P 500 by more than 10 per cent in the past 12 months and an annualized three per cent over the past five years. Global value stocks as represented by the Morningstar Developed Markets ex-north America Target Value Index have underperformed the MSCI EAFE by 10.3 per cent over the past year and approximately half a per cent annually over the past five years.

Interestingly, both Canadian and EAFE markets have almost turned into value plays themselves having both materially underperformed the S&P 500 by 3.8 and 5.3 per cent, respectively, in the past year and an annualized 4.3 and 3.5 per cent over the past five years.

According to Howard Silverblatt, a senior analyst for S&P Dow Jones Indices, the Top 10 companies accounted for nearly a third of the S&P 500’s move from 2000 in August 2014 to Friday’s record close above 3,000. Microsoft, Amazon, Apple and Facebook were the top four contributors accounting for more than 21 per cent of the index’s move. Compare this to the S&P/TSX where the top four companies in the index are the Royal Bank of Canada, Toronto-dominion Bank, Enbridge and Canadian National Railway.

From the research I’ve read, two main factors appear to be responsible for this divergence in performance — interest rates and technology.

Low interest rates have lowered the cost of capital dramatically while new technology has allowed for instant scaling among already established networks, thanks to the proliferation of the smartphone and its rapid connectivity. As a result, tech-based companies can run their businesses at a loss as long as they have access to inexpensive capital to fund rapid growth of recurring revenues. Traditional bricks-and-mortar industries, on the other hand, have not only overnight lost their moats but also their competitive advantage.

For example, Americans spent more on Airbnb last year than they did at all of Hilton’s properties, something that is astounding when one considers that Airbnb does not own a single hotel while Hilton has a portfolio of 5,757 properties in 113 countries.

Likewise, as digital payments giants such as Visa, Mastercard and Paypal are growing their networks around the world — and watching their valuations soar exponentially — Canada remains lodged in the bricks-and-mortar world. Consider this: we are the only country in the world whose largest publicly traded company is a bank.

Amid this shift to technology, we wonder if the whole idea of value investing is evolving as well.

As moats dry up, companies have to adapt quickly or risk losing market share.

For investors, this means the challenge is now to do enough homework to be able to sort the real values from the increasing number of portfolio-disrupting value traps out there.

We wonder if the whole idea of value investing is evolving as well. As moats dry up, companies have to adapt quickly or risk losing market share.

Financial Post Martin Pelletier, CFA, is a portfolio manager and OCIO at Trivest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.