The out­look for value in­vestors

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Finweek English Edition - - MARKET PLACE -

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past nine years have been tough for those man­agers em­ploy­ing the “value” style of in­vest­ing. In­vestors fol­low­ing the value style will try to iden­tify those com­pa­nies where they think the mar­ket is too pes­simistic about its fu­ture prospects – i.e. value in­vestors buy stocks they be­lieve the mar­ket has un­der­val­ued and whose fu­ture will be bet­ter than is cur­rently priced in.

For more than five years – from the in­cep­tion of the global fi­nan­cial cri­sis in early 2007, un­til half­way through 2014 – the value cy­cle un­der­per­formed the mar­ket by a cu­mu­la­tive 107%, one of the long­est and deep­est pe­ri­ods of un­der­per­for­mance of the value style. This is ac­cord­ing to anal­y­sis car­ried out by San­ford C. Bern­stein & Co. and Pzena In­vest­ment Man­age­ment, a New-York based firm that has been man­ag­ing as­sets since 1996.

Since early 2016 the value style be­gan once more to out­per­form the mar­ket, pro­duc­ing re­turns in ex­cess of the gen­eral mar­ket of about 20%. This was driven by com­pa­nies shunned by the mar­ket up to that point, as in­vestors were con­cerned about their abil­ity to gen­er­ate earn­ings growth. These com­pa­nies in­cluded those in the en­ergy sec­tor, which had ex­pe­ri­enced an ex­treme fall in the price of oil, and the ma­te­ri­als sec­tor, where min­ing com­pa­nies and com­mod­ity pro­duc­ers suf­fered from fall­ing com­mod­ity prices in a slow­ing global growth en­vi­ron­ment.

When global growth be­gan to re­cover slightly, the oil price sta­bilised, China be­gan to stim­u­late its econ­omy by in­fra­struc­ture de­vel­op­ment and com­mod­ity prices were driven up­wards. The mar­ket be­gan to im­prove its ex­pec­ta­tions for such com­pa­nies, re­sult­ing in their share prices ris­ing rapidly.

The start of a new value cy­cle?

Af­ter such a long and se­vere pe­riod of un­der­per­for­mance, in­vestors are ask­ing if this is the be­gin­ning of a pe­riod of out­per­for­mance for value, or if the cy­cle will be short-lived and the op­por­tu­nity to in­vest in the value style al­ready past.

The past 50 years show that pro-value cy­cles are typ­i­cally longer in du­ra­tion and greater in cu­mu­la­tive out­per­for­mance than the cur­rent cy­cle, which com­menced early in 2016, as can be seen in Graph 1. Value cy­cles in the US have lasted 72 months on av­er­age and gen­er­ated 162% ex­cess re­turns cu­mu­la­tively on av­er­age, ver­sus the 11 months and 20% re­spec­tively of the cur­rent value cy­cle.

Anal­y­sis car­ried out by Pzena shows the po­ten­tial dif­fer­ence in re­turns from the cheap­est quin­tile of shares com­pared to the broader mar­ket (termed the “val­u­a­tion spread”) re­mains wide through­out the world, es­pe­cially in fi­nan­cials and gen­er­ally cycli­cal busi­nesses.

One way of show­ing this is by look­ing at the price di­vided by the earn­ings (P/E) of the shares in the S&P 500 US eq­uity in­dex. The P/E is sim­ply the price mar­ket par­tic­i­pants are will­ing to pay for the ex­pected earn­ings one year out. If the P/E is low, it means the mar­ket will not pay a high price for the earn­ings – the shares are in­ex­pen­sive and this is where a value in­vestor might look for op­por­tu­ni­ties.

Anal­y­sis by ACPI In­vest­ment Mangers, which can be seen in Graph 2, shows how wide the dis­per­sion is be­tween the P/E ra­tios of the var­i­ous quin­tiles of this mar­ket. This val­u­a­tion spread means that there are many op­por­tu­ni­ties for pos­i­tive sur­prises in the cheaper part of the mar­ket, which pro­vides much po­ten­tial for value as a style to out­per­form.

Growth in­vest­ing

Av­er­age Cur­rent

Seen from an­other per­spec­tive, ex­tremely low in­ter­est rates in the US and else­where favoured eq­uity strate­gies that fo­cused on growth as op­posed to value Jul ‘73 - Mar ‘78 Dec ‘80 - Aug ‘88 Nov ‘90 - Aug ‘95 Mar ‘00 - Feb ‘07 Dec ‘08 - Jun ‘14 Feb ’16 - Dec ‘16 12.7% 23.0% 29.4% 55.1% 35.4% 31.1% 19.9% stocks. Growth in­vest­ing is an in­vest­ment style con­cen­trated on com­pa­nies whose earn­ings are ex­pected to grow at an aboveav­er­age rate rel­a­tive to its in­dus­try or the over­all mar­ket.

Mar­ket par­tic­i­pants are pre­pared to pay high prices for such com­pa­nies, be­cause they think that the com­pa­nies will, over a long pe­riod of time, grow at a faster rate than oth­ers. They are there­fore pre­pared to sac­ri­fice pay­ing a rel­a­tively large amount of cash now, be­cause they hope to ben­e­fit from the ef­fects of com­pound growth in the fu­ture. When in­ter­est rates are low, as they have been since the global fi­nan­cial cri­sis, in­vestors are even more pre­pared to part with cash than at other times, since the ben­e­fit of hold­ing cash or other “risk-free” as­sets, such as US gov­ern­ment bonds, is less than nor­mal.

This is why growth stocks vastly out­per­formed value stocks over the past years, which is rel­a­tively un­usual. Graph 3 high­lights this re­la­tion­ship since the 1930s and it shows that value typ­i­cally out­per­forms growth by a wide mar­gin.

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