As the Australian Securities Exchange (ASX) continued its rise throughout 2019 and into 2020, reaching new heights in February this year, some market commentators started to suggest that the end of the bull market cycle was approaching and with it, the end of the dominance of growth managers.
The COVID-19-induced market collapse in late February and March did indeed trigger the end of the bull market but it did not bring about the expected catalyst for value managers to come to the fore.
Value investing is supposed to perform best during market falls. But we’ve just seen a downturn – indeed, at time of writing, markets have already bounced back – and value managers have still not outperformed.
Why not? And is there still a place for value investing, or has the world changed too much?
PERFORMANCE OF VALUE
The key reason why value has underperformed, both over the last few years and indeed in this recent bear market, is that interest rates have gone only one way – lower!
At the heart of value investing is the concept of mean reversion – the theory that asset prices and historical returns eventually revert to their long-term mean: whether that reversion is impacting economies, industries, individual stocks or fundamental macroeconomic factors such as currencies and interest rates.
So while all companies benefit from a lower cost of capital as a result of low interest rates, they are not all impacted equally. Essentially long-duration assets (such as long bonds and growth stocks) have more of their cashflows in the future than shorter-duration assets (such as a value stock). In our view this is essentially why growth has done better than value in recent years.
We also note that interest rates are foreshadowing a very low growth period ahead, yet price earnings (P/E) multiples are still very elevated. At some stage we expect P/E multiples to contract, adversely impacting growth stocks.
Chart 1 highlights the outperformance of growth over value both in Australia and the US over the last decade. Remarkably, the performance in both markets is almost identical and the outperformance of growth has accelerated over the first half of 2020. We have rarely, if ever, seen such a sustained outperformance of any one strategy and would not be surprised that when a reversal occurs the response could be quite dramatic.
Another issue for investors to be aware of is that unusually (possibly uniquely), the stocks that led the market higher over the last few years also did best in the recent downturn. At the early stage of the downturn it was pretty clear that the favoured stocks continued to be favoured. The healthcare sector generally is a classic example of this.
As such, we are even more convinced that these stocks are overvalued and more recently it appears that the market is beginning to come around to this view, with some market analysts predicting a move by markets into a “second phase” which favours value and cyclical stocks.
Investors and their advisers should also keep in mind that the March market fall was probably not the “main event”. The stimulus measures put in place by the government – not just here in Australia but around the world – provided a substantial level of support to the economy and markets.
However, we believe it is still relatively early days in the current market cycle – indeed it would be very unusual if it was all over in three months. It is more likely that the true impact of the lockdown and the subsequent stress on company balance sheets, will not be fully felt until later in the year. Just like the second wave of the virus that health officials are warning about, it is possible there will be a second wave of market turmoil.
A ‘NEW NORMAL’?
A common theme of almost all market crises is that in the months beforehand, people start to believe that “this time, it’s different”. P/E multiples can keep rising; structured financial instruments are indestructible; all internet-related companies will inevitably deliver a huge profit. But the subsequent crisis reveals the reality that anything can come crashing down – there is no “new normal”.
As value managers, we believe that by combining a strong value discipline with a longer-term time horizon than most investors, we can exploit a regular and persistent inefficiency in markets often referred to as time arbitrage, as illustrated in Chart 2.
With most market participants increasingly taking a short-term view, both negative and positive news is compounded in terms of its impact on share prices, leaving opportunities for the patient long term value investor.
We strongly believe that the price you pay for an asset is critical to its success or otherwise as an investment, whereas in our experience most growth investors are less sensitive to price and more concerned with the potential growth on offer.
This doesn’t mean that we are “anti-growth” – in fact, we like growth just as much as the next investor. Where we seek to distinguish ourselves from other investors is what price or what multiples we are prepared to pay for that growth. History is littered with examples of buying stocks at any price (the dot-com bubble for example). We suspect that investors may well look back in years to come and wonder at the multiples paid for many of the favoured stocks today.
It is often said the darkest the hour is just before dawn and value investing has been particularly bleak over the last few years! Once again we are hearing “this time it is different” usually coupled with a comment along the lines of “interest rates will be low forever”. Whilst the chances of rising interest rates and inflationary pressures appear low in the short term, they cannot be dismissed. The only way Governments around the globe are ever going to repay the vast debts accumulated through this crisis is likely to involve inflating their way out of it.
It is hard work buying when everyone else is selling (and vice versa) but it is the only way you will outperform over the longer term. In our view “buying straw hats in winter” is still a very prudent philosophy.
Dougal Maple-Brown is head of Australian equities at Maple-Brown Abbott.