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.
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.
“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.”