RWC Partners’ Ian Lance looks into what investors are doing wrong when it comes to value, and whether now is the time to look at growth or value stocks.
Why has value done so badly for the last few years?
I suspect a large part of the answer is the environment that we have been in – namely one of falling interest rates and quantitative easing. From a mathematical point of view, this favours long duration assets (growth stocks) over short duration assets (value stocks). It has also encouraged risk-on – or speculative – behaviour because there is a belief in the central bank put option, that any decline in markets will be backstopped by central bank intervention.
If this is the case and the market will only go up, it may seem logical to own the highest beta stocks to benefit, although we don’t subscribe to this view. Finally, the sluggish economic recovery has meant that many stocks have struggled to show any growth and those that have been able to grow have become higher rated.
What will be the catalyst to turn this cycle particularly now it looks like interest rates have peaked?
Often there is no particular catalyst. In 2000, there was no defining event that caused the Nasdaq to roll over, it was just a case of valuations becoming so ridiculous that eventually you run out of new buyers and suddenly sellers exceeded buyers.
At this point, lots of holders of the stocks know the prices are not supported by fundamentals and decide to panic out. They then discover there are no buyers on the other side/lack of liquidity and prices start to spiral down, leading to more selling pressure.
I am not predicting that this is about to happen but merely pointing out that the conditions existing today are similar to those that existed in 2000 in terms of valuations.
Does technological disruption mean that value investing is dead?
It is worth stating that value investing is the process by which you buy something for less than its worth, whether it’s a share, a house, a painting or something else. That is never going to die. What we can say, however, is that historically, a naive value strategy of just buying a load of beaten up companies and waiting for the forces of mean reversion to get to work was quite effective.
Thanks to globalisation and technological disruption, however, in some cases means reversion now does not happen. For example, the number of retailers that have gone bust, in part because of the entry of Amazon to the market. We would therefore encourage investors to put more focus on researching whether the company’s business model was still robust and not in structural decline, as well as ensuring they had a strong enough balance sheet to make it through any downturn.
Aren’t there some businesses which are just so dominant that valuation is almost irrelevant?
While there are some businesses that look expensive in their early years, this does not stop the share price increasing as the profits grow – Amazon for instance; but they tend to be the exception rather than the rule. There are few, if any, investors who can identify these types of businesses in advance and history is littered with examples of companies which failed to live up to their potential. For example, the Nifty Fifty stocks or the Fortune list of stocks to own forever in 2000 which included companies such as Enron. In addition, a good business is not always a good investment. In 2000, Microsoft was an incredible business and its earnings per share grew by more than 170 per cent over the course of the next decade.
If you bought the shares in 2000, however, you had to wait for 14 years to get your money back – simply because the starting valuation was way too high. We believe that certain investors are making this mistake today and locking in a poor return from what might be good businesses by over-paying for them.
The Federal Reserve looks like it is about to cut rates, that should be good for growth stocks, shouldn’t it?
Mathematically it can be demonstrated that growth stocks should benefit from a reduction in the discount rate as they are long duration assets. In practice, however, things are rarely this simple.
Cuts in interest rates are frequently associated with an economic downturn which is rarely good for equities. The Fed was cutting interest rates aggressively in 2001 when the NASDAQ lost two-thirds of its value, and again in 2008-2009 when the US stock market halved. Reasonable quality but lowly valued businesses often fare better in this environment. Conversely, stocks where valuation had become disconnected from fundamentals can fall the hardest as momentum investors try to get out of them at the same time.
Ian Lance is manager of the TM RWC UK Equity Income fund