No pain no gain
It’s tough being a value investor these days. Beyond the general equity market decline, value has underperformed the broad developed equity market by nearly 6% in the first quarter.
Unfortunately, that was on top of nearly 6% underperformance last year, which pulled longer term average excess returns into negative territory as well. For any investor this is extremely painful, unquestionably so. And it begs many questions such as whether or not one should stick with such a tilt in one’s portfolio strategy, which is entirely reasonable.
Buying cheap produces superior investment results
This morning, when I looked at Bloomberg for good articles to read, I came across headlines such as a $15bn capital raising effort by Oaktree and a $7bn effort by Guggenheim to invest in distressed debt markets. Last week I read about other high-profile investors calling the current market turmoil “an opportunity of the century”. These headlines remind me of famous investors’ actions in the Global Financial Crisis of 2008. For example, Warren Buffet, not only one of the richest people on the planet but also one of the best investors, made a $5bn investment into Goldman Sachs shortly after Lehman Brothers collapsed. His success is, as an award winning paper1 from AQR has concluded, a result of pursuing defensive, high quality value opportunities (with leverage). Given that many readers have little or no experience of investment situations such as the current one, what can we learn from him and others about the course of actions we should pursue?
My former boss Rob Arnott, founder of Research Affiliates, one of the biggest Smart Beta providers globally and inventor of the RAFI methodology, which has a dynamic value exposure, has, like myself, already been a value investor in a period of value underperformance during the tech bubble (1998-2000) but, more importantly, prior to that, during the big value underperformance of the Iran Oil Crisis in 1979/1980. Because of his experience, he prefers to call the value ‘risk’ premium the value ‘fear’ premium. His rationale for doing so is that he has observed time after time that fear takes over from rational investment decision at precisely the wrong moments in time: After risk that investors expect to be rewarded for has materialised. As can be seen in the below chart, investors with all kinds of differing beliefs suffer from this phenomenon.
The above chart shows that the average dollar weighted returns, taking into account in and outflows from investments, are always much lower than time weighted returns, which are assuming a buy and hold approach. Average time weighted value and small cap returns, instead of beating the S&P 500, become inferior dollar weighted returns. This is a particularly surprising result for value investors, given that those investors know that the success of their chosen strategy is dependent on buying groups of securities when they are cheap. Fear, however, causes the average value investor to do the exact opposite and sell cheap groups of securities. MASECO is endeavouring on behalf of their clients not to turn into average value investors and lock in losses in value instead of enjoying the benefits of long term value investing. After all, there has never before been a 20-year period in history where value has not beaten market returns.
One of the most frequently asked questions is about ‘value traps’ and, of course, holding shares in failing companies is something to avoid if possible. I agree it is likely that more companies are going to fail in the next two years versus the last two years, though the numbers and scale will depend very much on the success and scale of efforts that most governments have already announced to avoid such scenarios. But more importantly, one needs to be conscious that all the numerous academic papers published in support of value investing include the impact of all value traps over the course of history. While failing companies receive extensive media attention, they are a much bigger issue for concentrated equity strategies than value strategies diversified across hundreds of stocks, because the exposure in those portfolios is much lower. Additionally, unless demand is changing, the failure of one company logically translates to the benefit of its competitors in the same industry. For example, if one airline fails, its competitors will benefit from more passengers as well as potential assets such as planes, staff or airport slots they may be able to acquire at a cheaper rate.
In relation to the above, some people look at the sector exposures of value strategies versus the broad market. That is usually because they know that most value strategies have an underweight to technology, which they believe is going to be detrimental to future performance. Having recently had a discussion with one of our managers, I wanted to share a design detail that some of our clients might not have been aware of until now. Like some other systematic managers, they believe that valuations should better be compared against industry peers and not across sectors and, therefore, their model portfolios are designed to be largely sector neutral. Our core equity value manager does not hold the same belief and therefore does not apply sector neutrality. As academia provides no clear guidance as to which belief has more rational and economic intuition, we welcome this additional diversification based on different portfolio construction.
For those approaches that are not sector neutral, please remember that for the most glamorous tech stocks to continue to outperform, they need to grow their fundamentals even more than the market has already priced in. Moreover, we all know that forces are already gathering against the size, powers and influence these companies have currently. Huge fines in Europe are just one example; a possible future Democratic US president could also be a game changer. The next decade could well see a less accommodative tax and regulatory environment for big technology companies. Finally, everything in finance and investing is somehow linked to the economic cycle, and both growth and value stocks are no exception and, as such, their performance is cyclical as well. The recent low interest rate environment has not been helpful for financials, which are often an overweighed sector in value strategies. In a recession scenario, which seems increasingly likely, tech stocks have much further to fall than value stocks. Corporate technology spending or advertising budgets are not immune to recessions. Another frequently asked question is if value investing stopped working because the drawdown of the value factor (High minus Low = HML) for US stocks as defined by Fama and French is the longest on record (see below):
It is comforting to see that all previous big drawdowns, even those that were greater in magnitude, recovered fully in periods of up to 3 years.
To understand what has happened and what might happen in the future, it is very useful to understand the driver of the underperformance. It is not a big improvement in the fundamentals of growth companies. Growth companies have always had better fundamentals than value companies. The answer is a change in valuation multiples. Valuations of growth companies have increased dramatically relative to value companies, to a point where the spread between them is now very close to the largest ever measured. For the reader interested in the details, I highly recommend exploring the recent research paper by Arnott, Harvey, Kalesnik and Linnainmaa: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3488748. It is the nature of valuations that they revert from extremes, so expected returns are always greater when valuations are extremely low.
The strongest argument for why not to shy away from value investing is its strong economic rationale, which was most famously written about conceptually by Graham and Dodd in 1934. The two Columbia professors introduced the idea that stocks with low prices relative to their intrinsic value could outperform the market over time. The concept was later embedded into asset pricing models by Fama and French in 1992. They rationalised value investing from a reward for risk perspective. Additionally, there is also a behavioural angle in support of value investing, popularised by Prof Shiller. Fama and Shiller’s work was given extra credibility as they simultaneously received the Nobel prize for Economics in 2013.
It is worth noting that Stacy Mintz, a quantitative equity portfolio manager at PGIM-owned QMA recently analyzed the implied earnings growth of current stock prices, they found that the median expensive company “would have to grow 25 percent every year for the next ten years to justify its price,” she explains. “For data like that, it feels like we must be near a turning point”.
What to do now?
No pain, no gain. If an investor walks away from value investing at a point in time when the pain has been the strongest due to underperformance, we believe that there could be much regret. Value can rebound very forcefully, as the below chart illustrates. The heavy underperformance by value versus growth in the year of the build-up of the tech bubble also caused longer term comparisons with growth to look unfavourable.
But just a year later the tide had turned completely. US Value stocks rebounded with a more than 45% performance advantage over US growth stocks. While we can neither forecast the timing nor the magnitude of a coming rebound, the signs from valuation spreads are pointing to a very similar situation.
I always think that if fear is in danger of leading us away from rationale investing and we are tempted to buy expensive securities (and historical performance that is in the past) and selling cheap we should remind ourselves of the Warren Buffet famous line of buying when others are fearful and selling when others are greedy. Remember, it is always darkest before dawn.
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