Judging value, through another lens
The style of investing that has attracted maximum derision in the last decade is value investing.
The aftermath of the 2008 crisis, in which central banks flooded economies and the markets with liquidity, effectively crushed the risk-free rate down to levels unseen before. The effect it had on growth equities was astonishing: the FAANG trade was born roughly one year after the GFC (global financial crisis) and did not look back until the end of 2020.
What essentially happened after the 2008 crisis was that even moderate expected growth became magnified in present value terms, simply because of a lowering of discount rates. This, in turn, inflated valuation multiples.
But things have changed a bit lately due to the hardening of yields, pretty muchacrosstheworld. Doesthis mean a return of value investing as high-flying tech stocks suffer from valuation compression?
It stands to reason that rising discount rates should result in the value space becoming more interesting. But how exactly should one define value?
The conventional methods include low price-to-earnings, low price-tobook, high free cash-flow yield, and low Ev/ebitda ratios. Their efficacy can be debated but that is not the point of this article.
Is there another lens through which we can define value? We think there is. How about looking at value in "real” terms, i.e. adjusted for inflation?
We looked at broad sectors globally and compared their real returns with their own history and relative to the broader market. We find some interesting patterns here and get some insights into what assets might be considered “value".
Relative to the broad S&P Global 1200 Index, sectors — such as energy, financials, industrials, and REITS — are trading in the bottom quintile/deciles of their 25-year percentile return ranges, while the recent high momentum sectors like information technology and consumer discretionary are within striking distance of their highest levels ever against the broader index since 1995!
When most new-economy sectors have delivered strong returns over 10-15 years, energy and financials have delivered flat or negative real returns in the past 15 years. In fact, REITS, financials, materials, and energy have remained at the lower end even when real returns are sorted by 10- and 15-year timeframes.
Additionally, within the S&P 500, the weighting of these sectors is currently at their lowest level in decades. Meanwhile, sectors like technology and consumer discretionary have the highest-ever allocations in the index (4 to 5 percentage points higher than their long-run average).
Even on an absolute basis, when the broader markets are already climbing to all-timehighs, sectors like energy (-38 per cent), REITS (-6 per cent), and financials (-2 per cent) are still trading significantly below their peaks of the past two decades in real terms.
Therefore, this is another way to define value — sectors and asset classes that have “cheapened” dramatically over a decade and more, in real terms.
This list of “Value” is pretty clear: Industrial commodities, financials, and purely from a dividend yield perspective, REITS.
These three broad classes represent the deepest value that exists in markets today and they also, therefore, represent the areas of maximum potential return in an era of rising yields and potentially higher inflation.
REITS, financials, materials, and energy have remained at the lower end even when real returns are sorted by 10- and 15-year timeframes
Hard commodities, such as industrial metals, are still trading well below their levels of 10 or even 15 years ago! The Industrial Metals index itself is down 25 per cent in real terms and 12 per cent in nominal terms over the last 10 years. Many individual metals have fallen even more.
Do physical a goods with related cost of mining and refining, selling at prices lower than 15 years ago, fit the definition of value? Certainly, there is a case for thinking so.
What’s also noticeable right now is the rising backwardation or roll yield. Over 12 months, that process — known as positive carry — currently returns 6-7 per cent in oil, 1 per cent in copper, 18 per cent in corn, and 16 per cent in soybeans. With yields from many of the more conventional asset classes depressed, this is something to be noted.
Real estate investment trusts
Then there are REITS, arguably one of the most underappreciated asset classes.
Even today, they are trading at a discount to their all-time highs and also relative to the market. More importantly, they still provide dividend yields of 4-8 per cent in dollar terms — at today's interest rates! Very “cheap" especially for the class of REITS that have not missed their dividend even during the pandemic turmoil.
By altering the lens through which we value “Value”, as we have done above, one can begin to see several asset classes, sectors that are trading at inflation-adjusted prices much lower than the previous 15 or 20 years.
In our worldview, the above are the best "true” value trades available in the world right now which hold the potential to beat other sectors and asset classes through the lessening of their long-term “cheapness”.