Disclaimers always advise that past performance should not be relied on as an indicator of future performance. However, what they should say is that past performance over long periods is a great indicator of future performance, but rather performance over the short-term is not.
Our clients often ask about the extremes of market pricing, and we tell them that most of the time these erratic swings can’t be explained by financial statements or some secret sauce knowledge, but rather more to do with human behaviour and investment psychology. It’s common that in the later stages of bull markets the most hyped up companies are the ones which attract investment. This is evidenced by recent speculative behaviour such as the rise of cryptocurrencies, retail investors with free brokerage, IPO’s of the latest and greatest technology and profitless growth companies reaching eye-watering valuations. Not surprisingly, this reflects the mindset of investors who feel invincible after 10+ years of outstanding returns in the most talked about sectors.
Just because a stock price rises doesn’t necessarily mean it is a good quality business, just because an investment manager has produced stellar returns recently doesn’t make them a good manager over the long term. Whilst it may seem counter-intuitive at the time, the data is overwhelming that the best time to invest with a great manager is during their years of underperformance. An investment manager who will likely outperform over the long-term must dare to be different, yet this is the most difficult aspect of investing.
This brings us to a topic we’ve written about before, but feel the time for a refresher is opportune in the current environment. That is of course, the history of value investing and its long-term outperformance over time. The topic of value vs growth investing is popular at the moment, so we thought we’d provide our view on why we are such high conviction value investors.
So, what is value investing exactly? Some financial commentators claim value investing is simply buying ‘cheap’ companies with low Price to Earnings (P/E) or low Price to Book (P/B) ratios. We think of it slightly differently. In principle, we invest in companies that are trading below what we believe is their intrinsic value. At its core, value investing is a common-sense approach – finding attractively priced assets, with scope to grow earnings that have sensible debt levels & typically have strong tangible asset backing. Whilst it is human nature to want to follow the crowd, long-term data suggests that investing this way – buying shares in companies that everybody else is buying – doesn’t actually work out all that well. When a stock disappoints for some reason and the share price goes down, people tend to overreact and the price can depreciate significantly. Value investors recognise that businesses have a long life and that short-term market swings do not materially change the long-term underlying worth of a business. This overreaction from the market often offers us exceptional buying opportunities.
The most common alternative to value investing is growth investing. This strategy involves investing in companies where earnings are expected to increase at a rate higher than the industry or overall market. These are usually (but not always) earlier stage companies that are expected to make large profits in the future. Key factors that growth investors look for are strong revenue or earnings growth, high profit margins, high returns on equity and an appreciating share price.
It’s important to remember that there is no hard and fast rule. A stock may be owned by a value and growth investor at the same time. It’s a fallacy that value investors are not interested in growth, but value investors attempt to buy assets with growth potential at a reasonable price. It’s also important to note that a particular stock does not stay a ‘value’ or ‘growth’ stock forever, see the Figure 1 below as an example of Apple Inc. P/E ratio:
Figure 1: NASDAQ:AAPL Fwd P/E from 2011 – 2021
Over very long periods of time, research suggests that value investing strategies outperform growth strategies by a substantial margin. Shown in Figure 2 below, since 1926 a balanced value strategy in the United States would have made your investment 50 times more valuable than a balanced growth strategy. Intuitively this makes sense, if you maintain the discipline of buying low and selling high, you should be rewarded handsomely over the long term.
Figure 2: Value investing outperformance over time (U.S)1
However, the last 12 years has been different relative to history, with growth strategies outperforming value by some margin across global markets. The low interest rate environment which has been magnified by trillions of dollars in government stimulus packages has helped balloon valuations of growth and loss-making companies. Traditionally, companies are valued by discounting their future cash flows back to present value. When a lower discount rate is applied, the value of future cash flows increases more than the value of present cash flows. An illustration is shown below:
Since the GFC, growth stocks have performed far better as investors have bought into the well-known tech companies that occupy the daily business headlines. This is unsurprising as growth strategies tend to outperform in a decreasing interest rate environment. However, at these share price levels, we believe that investors have become complacent and are taking on more and more risks by investing in loss making entities with popular growth narratives. Figure 3 illustrates growth’s outperformance over value in this time period. It is important to note that each time this anomaly of growth outperforming value strategies has occurred, it has been followed by a market crash. The pattern tends to repeat itself whereby investors become complacent with debt and paying high prices for companies with extremely high valuations, and get caught out time and time again. The only thing unique about the situation we are in now is the length of time that growth investing has outperformed. Some say “this time it’s different”, but we know these are the most dangerous words in investing. It is imperative that investors focus on the years ahead rather than the years past, and how the economic environment has changed.
Figure 3: Growth’s outperformance since the GFC2
Although market returns for the last decade or so have been heavily driven by growth stocks, and indiscriminate index investing has amplified this effect, we as benchmark agnostic value investors consider such stocks only when we think the price is right, and not because they are in an index or because they may have done well in the past.
There is a narrative that is extensively consuming growth investing at present that this time is different – and that the new technology avalanche that occupies the daily headlines – AI, cloud, electric vehicles, biotech, health tech, fintech, the Green revolution to name a few – provide unprecedented opportunities for growth we have never seen before and opportunities for unparalleled riches for those who can identify the next winner. The truth is, there has always been significant reward for those who had luck or skill and got in early with the gamechangers of any generation (think Nifty 50, General Electric, Bell, or the Argentinian railroads). Our approach is not to try and hit the ball out of the park with 1 gamechanger out of 100 attempts, rather to apply fundamental investing principles of investing in companies with cashflows we understand and at prices that represent value.
There are obvious signs of a top heavy market, which when some form of reversal happens, will lead portfolios with allocations to value to outperform:
- The meme stock frenzy is just the 21st century iteration of the shoeshine man advising JP Morgan on stocks pre 1929
- Interest rates are at 5000 year lows and simply will not remain at these levels for anything beyond the medium term,
- Investor infatuation with Tesla, Afterpay and other similar stocks is highly evocative of the 2001 dotcom reality check
We believe inflation is likely over the next decade which will undoubtedly lead to higher interest rates and funding costs, subsequently benefiting value stocks and bringing growth stocks back to reality.
We remain focused on company fundamentals such as the quality of management teams, cash flows, barriers to entry and low valuations and trust over time that this proves far more rewarding than following the momentum of the crowd. Today we can only find pockets of this value outside of the major stock indices, in small under the radar companies and we are seeing encouraging signs of this bearing fruit. As we look ahead, we do not focus on the short-term and continue to remain patient and stick to our strategy of investing for the medium to long-term in quality businesses at great prices as opportunities present themselves.
3 The underlying historical market data is provided by the Center for Research in Security Prices (CRSP). Fama/French construct a vast library of research portfolios based on this data, six of which are “6 Portfolios formed on Size and Book to Market.” Price, dividend, shares, and volume data are historically adjusted for split events to make data directly comparable at different times during the history of a security. The performance results are based upon a hypothetical model and has inherent limitations. Hypothetical performance does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risks associated with actual market conditions. There are numerous other factors related to the markets in general, or to the implementation of any specific trading strategy, which cannot be fully accounted for, and all of which can adversely affect actual trading results.