As GMO’s James Montier states, following a value strategy is like ‘having your arm broken on a regular basis – not fun!’ As a glance at the chart below demonstrates, the last 10 years for value investors has felt like having every bone in their body broken as growth trumped value month after month, year after year.
So why has ‘value’ as a strategy done so poorly for so long? It is very hard to know exactly why this has been the case but we do have several theories.
Growth stocks are like long duration bonds and benefit from declining interest rates
Growth stocks can therefore be thought of as having a longer duration or sensitivity to interest rates and when interest rates fall, as they have done for the last 10 years, it is these stocks which will perform the most favourably.
In a world of secular stagnation, growth becomes a rare commodity and is more highly valued
Despite unprecedented monetary and fiscal expansion, global economic growth in the last decade has been significantly slower than previous periods. For many companies in the UK especially, true top line growth has been hard to find since 2008 and therefore any company that does demonstrate growth has been in demand and thus re-rated to the point where valuation is almost irrelevant so long as the growth rate continues.
The age of disruption
Just like two other periods when value underperformed growth significantly, (the Nifty Fifty period of the 1960s and the TMT boom of the late nineties), today’s market is associated with a convincing narrative about a group of companies that investors believe are set to dominate the world.
In the 60s investors thought companies like Texas Instruments, Xerox, Polaroid and Eastman Kodak (the Nifty Fifty stocks) would grow to the skies and consequently re-rated them dramatically. In the 90s, they were equally convinced by Dell, Microsoft, Cisco and Intel and these four stocks (dubbed the four horsemen) accounted for 55 per cent of Nasdaq’s gains during 1999.
Today’s market darlings have also been given an acronym – FANGMAN in the US (Facebook, Apple, Netflix, Google, Microsoft, Amazon and Nvidia). The expectations for all these companies eventually become so high, that any signs of a slowdown are severely punished as shareholders in Facebook discovered recently when the shares dropped by 20 per cent on the day of their Q2 results.
Performance chasing strategies have drifted to ‘quality growth’
Momentum-oriented investors have piled into the ‘quality growth’ trade and many fund managers who market themselves as ‘blend or core’ investors have drifted towards being ‘growth’ as the chart below demonstrates.
This seems to suggest that many fund managers have been committing what I believe is the cardinal sin of performance chasing style drift – as growth has done well, so managers have felt obliged to shift their exposure in that direction in order to safeguard their assets and/or their jobs.
This drift has meant that, more than ever, value managers are in the minority and only represent circa 12 per cent of the fund universe, whilst two-thirds of the industry’s assets have shifted to growth. It is not difficult to imagine what might happen to the relative performance of growth and value strategies if at least some of this money starts to move back in the other direction.
‘Quality growth’ was a great asset gathering strategy – Caveat Emptor!
Large swathes of the fund management industry are in the business of gathering assets and will therefore tend to flog what is hot as this tends to be the easiest sell. With ‘quality growth’ over the last eight years, the fund management industry (especially in the UK) has spotted a great marketing strategy which has been given impetus by the fact that it has worked in recent years (marketing departments exploiting recency bias).
Quality growth was also a dream sales story – who doesn’t want to buy great businesses with dependable moats especially when they seem to go up by more than the wider market every year! Billions have been raised by funds with names like ‘Franchise’ ‘Quality’ or ‘Brands’ in the title and whose top 10 will regularly feature companies such as BATS, Unilever, Nestle, Diageo and Reckitt Benkiser irrespective of how highly valued the shares were.
There are two potential pitfalls with this quality growth trade.
Firstly, we have found that there is very little evidence to suggest that quality as a standalone strategy adds any value (logically, why would you expect to earn a premium from investing in less risky, higher quality companies?).
Secondly, history suggests that where recent above average returns have resulted from valuation expansion, future returns are likely to be much lower as valuations mean reverted. This prediction has come true much faster than we could have expected as the inflated share prices of many of these stocks have come down to meet the deteriorating fundamentals of the underlying businesses (the share price of Imperial Brands nearly halved from its recent peak a few weeks ago).
So why might this be about to change?
At the macro level, we believe that the forces that drove the outperformance of quality growth over the last ten years are set to change, specifically quantitative easing is becoming quantitative tightening and interest rates are beginning to normalise. Historically the outperformance of growth ends when the expectations baked in to valuations are so high, that any signs of disappointment is severely punished.
The recent declines in stocks like Facebook, Tesla, Twitter, and Netflix suggest we may have already reached that point. Conversely, expectations for some of the classic value stocks in sectors such as energy are so low that risks seem skewed to the upside.
Finally, declarations from smug growth fund managers that ‘value investing is dead’ and redemptions from value funds are also classic signs that the growth/value cycle has peaked. After 10 long years of value underperformance, it seems likely that we have finally reached a turning point.
Ian Lance is co-manager of the RWC Income Opportunities fund. The views expressed above are his own and should not be taken as investment advice.