Value investing

However, it’s unlikely such observations would provide much solace for an investor that came to the market 10 years ago armed with these lessons from history. That’s because we’ve just witnessed a decade in which the returns from growth investing have obliterated those from value. Indeed, since the end of 2006, an investor that backed the MSCI Growth index would have outperformed an investor that backed the Value index by a third.

The 10-year chart, above, makes an uncomfortable sight for anyone that has firmly pinned their colours to the mast of value. Indeed, anyone looking for evidence of value’s sustained long-term outperformance needs to trawl back to November 2000, when the tech crash was smashing growth stocks.

“The length of the underperformance of value to growth is unprecedented and the degree of underperformance is comparable to the tech bubble,” says Andrew Goodwin, a partner at value-orientated asset manager Oldfield Partners.

After such a long and profound period of underperformance by value, the question investors need to ask is whether we are looking at a new paradigm or if in fact a huge opportunity now exists in value stocks as long-established historic trends reassert themselves and the experience of the past decade goes into reverse.

The 10 largest constituents of each index as of 30 September 2016 were:

MSCI World Value Top 10

MSCI World Growth Top 10

Source: MSCI

What's going on?

The credit crunch and its aftermath seem to have been a clear marker for the change in fortunes for value relative to growth. Indeed, just as the tech crash hammered the ratings attached to growth stocks, the credit crunch smashed the earnings being produced by value stocks. Sentiment has suffered since then towards some key value sectors, such as financials. What’s more, during the developed world’s stuttering economic recovery that has followed the financial crisis, it has only been the MSCI World Growth index that has produced sustained earnings growth, while the Value index has seen earnings gradually decline following an initial post-crisis rebound. This is particularly evident looking at the chart of the past five years (see below), which excludes the period of sharp recovery in value earnings following the global financial collapse.

The post-credit crunch economic environment, as well as the medicine used to deal with financial collapse, has left a bitter taste for value investors. Value stocks are often reliant on external factors to assist sales and profit growth and have therefore lacked an important tailwind due to the tepid GDP growth in most developed economies over the past decade and anaemic inflation (at times when inflation has been high a key cause has been rising input prices caused by emerging market demand rather than the bidding up of prices of end products).

But if there is a macroeconomic master villain, then in the eyes of most value investors it is the ultra-loose monetary policies pursued by central banks. There are good reasons to think the drop in the cost of capital associated with ultra-low interest rates may have caused returns to suffer severely in some of the sectors that are typically home to value stocks.

“One of the bases of capitalism is creative destruction,” says Matthew Jennings, investment director of Fidelity Worldwide Investments. “Most people would agree that the reason why value investing works, which most academic studies show it has over the long term, is mean reversion. [Mean reversion] is an extremely powerful force in open markets. One of the things I suspect has hurt value investing as a style is that very low and negative interest rates have prevented mean reversion from happening. Under normal circumstances, if a company or a sector is not producing an adequate return, capital will be withdrawn, which will allow prices and margins to recover as competition withdraws. The problem has been because central banks have insisted on micromanaging the economy and markets, and this has prevented supply leaving. There are a lot of zombie companies at present in the world, which are only about because of easy financing.”

Is there value in 'value'?

If value stocks do offer strong potential of reversing their decade-long trend of underperforming growth, one would hope to see the emergence of value in ‘value’. However, comparing the earnings multiples (PE ratio) of the MSCI Growth and Value indices, there is little evidence of this. Indeed, while many commentators are worried about the high ratings commanded by big-name technology stocks such as Amazon and Facebook, as well as so-called bond proxies, the actual forward PE premium the MSCI World Growth index commands compared with the Value index has remained stable for the past decade and even fallen slightly in recent years. True, studies that have looked at the market’s lowest and most highly rated stocks have found some very marked divergence, but the general picture as represented by the MSCI World indices does not look extreme. This can be seen in charts 5 and 6, which show Growth’s PE premium based on next 12-month consensus earnings forecasts.

What is really noteworthy about the earnings multiples for both the Growth and Value indices is that they look high compared with the historic range. Indeed, the ratings commanded by both indices are well within the top fifth of the 10-year range. For the Value index, the earnings multiple has inflated despite the disappointing earnings growth noted earlier.

However, the danger of high PE ratios is perhaps more noteworthy for growth stocks than value stocks, as historically the MSCI World Growth index has tended to suffer larger de-ratings during tough markets. Value stocks have offered investors more stable PEs, but have offset this advantage by having less stable earnings on which those ratings are based. Indeed, since 1975 both indices have experienced similar maximum drawdowns (the maximum loss an investor could have incurred by buying at the top and selling at the bottom) of 57 per cent for the MSCI World Growth index during the tech crash and 61 per cent for the Value index during the financial crisis.

While PEs don’t present a convincing valuation case for value stocks, another classic measure of value, the price-to-book-value (P/BV) ratio, offers a more credible argument. Not only is the P/BV of the Value index low by historic standards, being in the bottom third of the 20-year range (see table above right), but there is a clear divergence in P/BV between the Value and Growth indices over the past 10 years.

What’s more, research from Franklin Templeton earlier this year found the divergence in P/BV between the most expensive and cheapest 10 per cent of the MSCI World index on an industry-neutral basis had got as wide as it was during the dot-com boom.

Valuations over 10 years

Valuations since start of data set*

*P/BV since March 1995, fwd PE since March 1998

The relatively low P/BV looks particularly interesting in light of the fact that a lack of earnings growth seems to have been a key factor holding back the performance of value stocks over the past decade. This is because book value can be regarded as a measure of the latent earning potential of a company or sector based on its past investment in capital. The market tends to assign a low P/BV to companies at times when they are producing disappointing returns from their capital. However, value investors that target low P/BV stocks generally do so in the belief that a fall in a company’s return on capital is often only temporary and due to specific external or internal factors.

The belief that returns will generally trend back up over time is in essence a play on the ‘reversion to the mean’ phenomenon. Indeed, the relatively low price being put on the capital of value stocks chimes with the view expressed by Fidelity’s Mr Jennings regarding the negative impact a very low cost of capital has had on performance. So while PEs look high for both value and growth stocks, a decent valuation argument can be made for value stocks based on their being less susceptible to PE de-ratings, and the potential for profits to rise as return on capital reverts to the mean. And a tightening of monetary policy looks as though it could be a potential catalyst to make both these attributes shine through.

More value or more value traps?

However, there are grounds to speculate that many companies that rely on high levels of capital to give themselves a competitive advantage may simply face a less productive future. The so-called ‘information revolution’ has seen tech upstarts irrevocably disrupt entire industries, from publishing to retail. These upstarts have brought technological innovation into long-established industries and many incumbents that have not been fleet of foot have seen return on capital obliterated as a result.

Indeed, earlier this year James Anderson, co-manager of the £4.4bn Scottish Mortgage Investment Trust and a vocal backer of the likes of Tesla and Amazon, was emboldened enough by the disruptive potential of the companies his fund backs to declare that within 10 years 69 of the world’s largest 100 companies are “doomed”. His comments were made with particular reference to the potential for electric cars, such as those produced by Tesla, to seriously erode the market for oil companies in the future.

Catharine Flood of Scottish Mortgage says: “One of the first things we look at when investing is the longevity of a company based on whether it is making enough of an investment in future growth. If companies are paying out cash, that is something we’d often be concerned about if it means they’re not investing enough for the future... If you look at what Tesla is doing with electric cars, many of the mass-market combustion-engine car producers are several capital expenditure cycles behind.”

However, while pure-play stocks such as Tesla, which don’t have vulnerable legacy operations, offer big attractions for high-conviction growth investors like Scottish Mortgage, technological change also provides opportunities for incumbents that are prepared to grasp the nettle. Mr Goodwin of Oldfield says: “It’s great what is happening with technology, but people focus on the opportunities for companies like Tesla. They ignore incumbent companies like GM, which actually has a Tesla within it. GM will produce its Bolt car a year before Tesla in volume and at the right price point.”

It’s the economy stupid

However, as far as big-picture arguments go, it is the impact of monetary policy on the performance of value stocks that is likely to remain the key focus. Following an initial rise in US interest rates at the end of last year, there are growing expectations that, despite many false dawns, another upward nudge from the Fed is not far off.

“The great financial crash has seen an extraordinary period of monetary stimulus. What we’ve seen is growth stocks where valuations have expanded because of the ever-lowering discount rates that future earnings are valued on. And bond-proxies – shares in those companies seen as having a low volatility of earnings – have become a crowded part of the market that investors have flocked into,” says Oldfield’s Mr Goodwin. “For us the tide is turning for value investing. We’d point to February this year as the real turning point... We think the change in interest rate policy in the US is the catalyst of change. It’s about the direction of travel. Previously it has been ever lower. Now that direction of travel has changed.”

Indeed, the outperformance of value following an upturn in the interest rate cycle has clear precedents. Research by Franklin Templeton found that between 1975 and 2007, following the first rate hike in each of the six interest-rate cycles during the period, all equities tended to perform well. However, The MSCI World Value index did better, on average returning 50 per cent in the three years following the first rate hike, compared with just over 30 per cent from the Growth index.

Laughing all the way to the bank

The prospects for value in the event of a further monetary tightening look interesting on a sector-specific basis, too. Monetary policy is of particular significance to investors in the financials sector, which accounted for more than a quarter of the MSCI World Value index at the end of September, giving it by far the largest sector weighting. Based on Thomson Datastream data, the correlation between the two-year US Treasury yield and the S&P 500 financial sector over the past 20 years is 0.51. And while it is always hard to determine causation when looking at simple statistics, the raw correlation number suggests movements in short-term bond yields have explained about a quarter of the sector’s performance over that period (see graphs, below).

Importantly, not only are short-term bond yields now rising (reflecting falling bond prices) due to expectations of an imminent second Fed hike, but the yield curve (the difference between short-term and long-term bond yields) is steepening. A steepening yield curve is often regarded as a cause of rising bank profits due to banks’ business model of funding long-term lending with short-term borrowing.

What’s more, while the valuation of the MSCI World Financial sector is around the middle of its historic range on a PE basis (that’s actually very cheap compared with where the rest of the MSCI World index trades), on P/BV the sector is in the lowest 13 per cent of the valuation range established since 1995 (the earliest point from which data is available).

There are other reasons at the sector level to think value could be primed to make a comeback. Energy is the second largest component of the Value index at 12 per cent. Share prices here have been on the rise as the forces of ‘creative destruction’ have squeezed supply following the collapse in commodity prices in 2014 and 2015.

Healthcare, which is the third-largest constituent of the Value index at 10 per cent, has also been attracting contrarian interest. The sector has become a political punch bag during the US presidential race due to very aggressive pricing by some companies. Many commentators believe share price falls have been indiscriminate and that many stocks could rebound once the market gets more clarity about the future direction of regulation.

Reports of my death are greatly exaggerated

The possibility that a change in favour of value over growth is already upon us is to some extent supported by the experience of the past year when the MSCI World Value index has actually squeezed marginally ahead of Growth on a total return basis. However, the shift is far from seismic and it’s worth keeping in mind that value showed year-on-year outperformance for most of 2013 – during the taper tantrum and associated rise in bond yields – before reverting back to the more familiar form of the last decade.

But even for investors whose belief in value investing has been left in tatters after 10 lousy years, ignoring value stocks may still be foolhardy for one very good reason offered by Fidelity’s Mr Jennings.

“Investors need to be diversified to build a portfolio that will thrive in all environments,” says Mr Jennings. “If an investor is happy at the moment because everything they’ve held has done well, whether it be bonds or equities, then it has probably done well for the same reasons [low interest rates]. That’s not diversification. They need to start looking elsewhere. If you want diversification, you must look to those parts of the market that have not been performing, and that’s value.”

What’s more, while value has endured a 10-year stretch that may have shaken the foundations of many investors’ heartfelt beliefs, a strong value discipline has still been able to produce outperformance when applied diligently and well. Proof of this can be found in the 10-year performance of our own Simon Thompson’s annual Bargain Shares portfolio, which takes much of its inspiration from the “father” of value investing, Benjamin Graham. Many value-orientated funds have also been able to produce ample outperformance of the index during this tough period. Details of a selection of such funds, along with a number of value ETFs, can be found in the tables on the right for anyone looking to get some contrarian exposure.