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Do you believe in gravity?

The value in value investing.

The last 10 years have been tough for value investors. Not just in South Africa, but across the globe, value stocks have underperformed.

As the graph below shows, this is the only period in the last 80 years in which value has shown a sustained negative performance relative to growth. It is a noteworthy reversal for an investment approach that had consistently delivered superior results for nearly a century.

Source: SIM analysis, Professor Fama’s data library, Tuck University

Does this mean that value investing no longer works? Has something fundamentally changed in the world economy and world markets such that the approach of buying stocks perceived to be cheap and expecting them to revert to the mean doesn’t pay off any more?

For Nick Kirrage, a fund manager within the value investment team at Schroders, it’s clear that many people are thinking this way. An analysis of equity funds across the world shows that 90% of them now have a growth bias.

The wood from the trees

The reason is quite obviously because this is what has worked. If you haven’t been investing in growth stocks, and particularly US technology stocks, you have been missing out.

Kirrage, however, believes that it’s dangerous to extrapolate this into the future.

“The Germans have an expression: ‘Tall trees don’t grow to the sky’,” he told the Allan Gray Investment Summit this month. “Nothing goes on forever.”

It might seem like the current trend has no obvious reason to end, but Kirrage expressed a simple view:

“I get asked a lot: ‘This trend has been going on now for 10 years. What is going to change it?’ And when I hear that, I always think exactly the same thing: ‘Gravity’.”

The graph below shows how dominant the US market, and particularly US growth, US momentum and US technology stocks, have been since the global financial crisis. Nothing else has kept pace.

Source: Schroders, Thomson Reuters Datastream

“The US is now 62% of the global benchmark,” Kirrage pointed out. “It has only been this expensive once in its history, and that was the dotcom bubble. My memory is that that didn’t end well.”

In fact, he feels that the market has already been giving warning signs.

“In December something happened to the world,” he noted. “It had a complete and utter reversion. Suddenly the world found gravity. Everything that had been going to the moon like tech and the US had a shocker and suddenly value stocks looked like safe havens.”

While there has subsequently been a return to the growth theme, this episode suggests that things can change very quickly. In that environment, Kirrage argued, value becomes an insurance policy.

“If you are the kind of person who worries a little bit that tall trees don’t grow to the sky, then now might be the time to consider diversifying and considering an insurance policy,” he said. “Why? Because almost nobody else out there is.”

The local market

This is true for South Africa as well. Even though the JSE’s performance has been poor for some time, that doesn’t mean it can’t get worse. If that were to happen, however, it’s the more expensive parts of the market that would probably be most affected. The unloved sectors of the JSE that many investors have abandoned would be the places to find insurance.

In particular, these would be companies operating in the South African economy that have been sold down due to concerns about local growth. This might sound counter-intuitive, but value investing often is.

“There is a lot of crowding into asset classes and securities that are perceived to be the right ones to be in now,” PSG Asset Management’s Shaun le Roux told the Glacier Investment Summit earlier in July. “But we think clients need to be very aware of what is at play. If you are prepared to be invested in areas of discomfort where prices are low, we think long term returns are going to be better.”

Investing in local companies is certainly uncomfortable for many people when the economy is under as much pressure as it is, but that is where value is to be found – in counters trading on low price-to-earnings multiples, and historically low earnings.

An example for Duncan Artus of Allan Gray is travel and leisure stocks. When consumers are under pressure, their spending on recreation obviously suffers, and this is reflected in the fortunes of these companies.

“Sun International’s share price in dollars is lower than it was in 1984,” Artus pointed out at the Allan Gray Investment Summit. “There have been a number of mistakes by management, the economy has been tough, and they have had way to much debt, but they are earning a fraction of what they did five or six years ago and the new management team is trying to get things right. We think they have a very good portfolio of assets, and it’s very depressed.”

That is the kind of share that is unlikely to take much more pain than it already has. The upside potential of a turnaround is however high. It may be an uncomfortable investment, but as Kirrage noted, doing the easy thing in life rarely delivers the best results.

“From my perspective the reason that value is having a tough time is that value is doing what sucks,” he said. “In investing, we continually look to do what’s comfortable, but the reality is that nothing else in our lives is like that. If you want to get fit, go to the gym for an hour every day. It’s uncomfortable. But in investing we’re looking for an easy life, and that just doesn’t’ fit with what I understand about how the world works.”

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Has something fundamentally changed in the world economy and world markets such that the approach of buying stocks perceived to be cheap and expecting them to revert to the mean doesn’t pay off any more?

Duh?

Yes!

You will never hear this at any investment conference but the global economy is headed for permanent decline. So is South Africa – except with us it’s easier to see. Economic growth since the 70’s has been built on credt expansion and it’s running into multiple limits. So strong are these limits that they rule out a return to any meaningful recovery. They are things like energy constraints, climate damage, and the simple fact that maintaining our business as usual takes the resources of about 3 earths.

According to Ludwig von Mises,[11] “[t]here is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved”.

We have kicked the can down the road for so long, and we now have no option but to double down on it – so we are headed for a total trashing of all currencies.

Funnily enough this should be great for stocks, think how the Zimbabwean stock market boomed with currency hyper inflation.

But before we get to this endgame it doesn’t mean that there won’t be another crash that will wipe out many of the banks and/or companies like sun international. It’s totally possible.

So good luck to anyone filling their boots with sun international shares at the moment. I wouldn’t touch them.

I agree 100%. The Austrian school is the only school that explains and predicts the boom-and-bust cycle. Central Banks have a monopoly on the issuance of currency. The most important part of any economy, the availability and price of money, is centrally planned. We do not have free markets any more. The IMF is the central planner for central planners. We all know that central planning of the economy always ends in disaster. Central planning by Central Banks makes the system inherently unstable and volatile.

If we understand the system, we can use it to our advantage. One thing is certain though, value investing died in 1971 with the Nixon Shock, and then it died again in 1981 when financial engineering started a huge bubble in credit inflation. Value investing will only come to life again if the world returns to a stable currency, the gold standard, without a fractional reserve banking system. Until then, the trend is your friend.

Thanks Patrick,

Kirrage etc. word their narrative craftily.

* Nowhere do they mention how to define value.. thats cos no one can agree on a definition. Eskom could be a value stock (depressed earnings vs assets)

* Value is not insurance: it goes down with the rest of the market,

* Value outperformance: doesn’t = positive returns. Just goes down by less than growth.. but still goes down in bear markets.

* US data is meaningless on the home front. Where are the studies of value stocks in post colonial Africa? Non? Perhaps because stocks go from value to deep value to bankrupt?

* Equating uncomfortableness with success in investing defies any logic.

Value stocks may may limit your losses in a bear market, but doesn’t mean you’ll come out with positive returns either.

Remember – if the US sneezes… we will get bronchitis (not just a cold), so be prepared to see 40% downside to whatever you perceive as cheap or undervalued now. Should there be a correction internationally (and gravity sensibly returns) – we will see red! Only then does the adage “buy on the cannons and sell on the trumpets” make sense… but who will be liquid enough then?

Here is an analogy for the value investing:

My wife and I go fruit shopping. She picks a bag of bananas for R10. I spot a box of bananas in the bargain bin for R5 (mostly rotting of course).

We leave the bananas overnight on the kitchen table and they enter a bear market of rot. Wife’s bananas value falls to R5, my box falls to R3.

I tell my wife my box outperformed the All Banana Index cos they lost less value than hers. She sarcastically congratulates my value investing and tells me to take my management fee + performance fees for my brilliance.. and go eat my box of rotten bananas myself.

Tech stocks have changed the game for the moment. Maybe forever. In the same way Cryprocurrencies will change the game with money in the future. The only difference being, there were no rules when tech stocks took off, it was the Wild West for institutions ( just look at Naspers). It won’t be the same with Cryptocurrency as Banks are already highlighting regulatory procedure that crypto will have to face.
Just my opinion.

Of course investing has changed. Not so long ago I read idiots opinions on this very site as to the value of Naspers for example. I see to recall an analyst being nervous at R800 bucks per share. Well quite frankly there is a new everything out there. Most older folk do not even know what 10 cent does for example. Most people dont know that We Chat is one of the largest trading platforms in the world. That is actually ok not everyone is expected to know everything about everything and that includes analysts but then they should rather not try and advise on it. There are billionair children trading crypto currency right now as I type this.

Our very own market is regulated in terms of offshore investing resulting in the majority of the statutory pension and retirement deductions being forced into local market equities. With very few places to invest these billions we create a false shortage of shares thus inflating share prices of mediocre performing companies. This will only get worse until there is no where to invest locally.

Millions of traders world wide have high speed internet access and real time data. These guys can move markets from the comfort of their own study in real time. So yes the world has changed.

In the USA people are beginning to understand the “tech”, more people have money to invest, investors are wiser and more agile. So yes I think the world has changed completely and change is speeding up all the time. Will there be a crash. Well history says so so it must be right. The thing I love about analysts is they only need to stick to their story and they will eventually be right then they can say “i told you so”. The only thing I know for sure is that for some reason people always want gold.

“Now might be the time to consider diversifying and considering an insurance policy [buying value stocks],” he said. “Why? Because almost nobody else out there is.”

Almost nobody else? So all these value stocks out there – they are sitting on a shelf, owned by nobody?

That’s the problem with active fund managers – very little of what they say about investing stands up to logic. But it’s easier to spin stories that way.

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