One of the most baffling questions for investors in recent years has been the excessive and, we would say, egregious valuations we have witnessed with growth equities. With some commentary beginning to surface suggesting that value might be on the come back, we give our two cents on the issue.
One of the most baffling questions for investors in recent years has been the excessive and, we would say, egregious valuations we have witnessed with growth equities. In Australia this is demonstrated through the lofty valuations of the WAAAX stocks and the somewhat bubble like characteristics exhibited by companies such as the now infamous iSignthis (ISX.ASX). This makes it a terrible time for traditional value based investors. Indeed, with cost of capital looking to go zero bound, metrics like debt-to-book ratios seem to be irrelevant. This has led an increasing number of investors to question the ways in which they look at investing. Perhaps the most telling sign has been the underperformance of that esteemed stalwart of value investing Berkshire Hathaway to the broader index over the past five years.
Is value dead?
So this brings us back to the question, is value dead? And so does it also follow and make more sense to just invest in the market rather than pick a portfolio. This is an especially important question. With premium valuations across even safe assets such as sovereigns and bonds (with now 17 trillion dollars in negative yielding debt globally) this is an environment unprecedented in most of our lifetimes. We shall come back to the latter topic at another time as that in itself warrants an explanation since most market participants misunderstand what the term negative yield means. Suffice it to say and as we are sure most readers have heard, there seem to be mixed messages across different asset classes. If one were to believe bond valuations then we are heading inexorably towards imminent recession and if one looks towards equities then the opposite is the case.
What caught our attention recently was when sectors such as energy and financials outperformed their high growth counterparts in the US earlier this week. Even taking out the one-off impact of potential upward pressure on oil following the recent Saudi attack, what we saw was a significant outperformance of value over growth. It had led many commentators perhaps preemptively to suggest that value is now back in vogue. The loudest voice being JP Morgan.
Call us cynics if you wish but we do remain somewhat cynical that this is the case. At any given point in time, different factors tend to be more important in any given market context. In an environment characterised by unprecedented central bank intervention in the open markets and an extended period of low interest rates it is not unexpected that investors would pay up for growth assets. This is especially true if there is an expectation that said regulators might step in should there be any headwinds, we here at TAMIM like to call it public risk and privatised profit. What is rather hilarious (if one has a rather dark sense of humour) is that market participants like to think it might be a particularly good idea that one would buy perceived risk assets at a premium and then hedge those bets by also buying overvalued bonds (what one commentator referred to as the dumbbell portfolio). However we do think that the market has some semblance of truth/right in this instance.
It might be counterproductive that we, as stock-pickers with a decided value bend, might say this but unfortunately, as the old saying goes, one cannot fight the central bank. We actually see a scenario where globally the central banks might, rather than try and unravel their QE programs, actually let the financial assets on their balance sheets hold till maturity at which point they would go into negative equity (fortunately for them, unlike other financial institutions, they cannot go bankrupt). We also see a scenario where they continue to step in, despite having very little dry ammunition left to use, by intervening directly in the markets. They might have very little ammunition in terms of playing with the interest rates - really their best tool for impacting the real economy - but they seem to have an infinite amount of ammunition in terms of holding up asset prices through open market transactions and the ECB’s now routine bond-buying program. We wait with bated breath to see a similar trend unfold locally should push come to shove.
So what does all this mean?
We think that equity markets continue upon their upward trajectory in the near term and growth assets will continue to do well and outperform over the medium term. However, the longer term scenario is somewhat different, the key phrase to remember here is, as boring as it may sound, ‘reversion to the mean’. Although specific factors might play an outsized role at any given point in time, it always evens out over a long term time horizon.
When this reversion might occur is one question we refuse to give an answer to for one simple reason. We just do not know. Market timing is an interesting question that too many investors get wrong too often. It is a fact that more money has been lost trying to undertake the exercise in futility that is timing the market than has been lost by staying invested. We continue to believe that the first rule of investing is not to lose money and not to forget said rule.
What is required for this dichotomy to change is a reversion of course from a monetary and fiscal point of view. It will come but if the past is to be repeated than look no further than our own regional heavyweight when it comes to unconventional policy making, Japan, to realise that this will be a long-time coming. Put simply, this a unidirectional policy move, quite hard to unravel for the rather simple reason that noone wants to be responsible for firing the first shot. Point in case being Powell through late last year before the Tweeter in Chief had something to say along with the markets.
How do we live with a problem we can’t change?
We must continue to emphasise that we are by no means saying that value is dead. Rather, that it is in a rather deep stupor which, in the absence of any policy shifts that might see normalisation in both the rates and fiscal environment, will stay there. But (there’s always a but, isn’t there) as one of our colleagues likes to put it, there is certainly something to be said for holding a portfolio that allows you to sleep better at night with the knowledge that you won’t wake up tomorrow morning with a rather nasty aftertaste in your mouth. One has never gone wrong holding good businesses with good management that generate consistent returns over a long period of time. This rings especially true if said business was bought at a good price and is part of an industry with a secular growth story or tailwind. As for the tactical allocations, we can always diversify our “bets” by having certain pockets, such as private credit markets, that leave us some breathing space should there be volatility in equity markets. The key is to buy good businesses and, from a portfolio perspective, have enough cash generated to ride out the volatility and give you additional powder to double down should you get better prices.
The other question is can stock-pickers provide additional value in this environment? Let us be straightforward in saying maybe not as it currently stands. This is a rising-tide and it takes everything up with it. They only way we can still consistently add some additional value is to look at under-rated stocks or differentiated streams of return. Whether this is looking outside of the traditional blue-chip stocks (i.e. small-caps) or where there is information asymmetry (in economic terms where there is incomplete information or one party knows more about something than another) an example of which could be Asian equities. Where the incomplete information and nature of the market structure allow the more discerning investors to actually beat the market over a consistent time frame. This also happens to be why we believe that most fund managers and active investors have underperformed the market in recent years. It isn’t that they have all of a sudden run out of ideas or that their collective IQ dropped overnight, it is rather that in order for their work to be of use the market has to have the ability to reward and distinguish between good companies and bad. To put another way, if the cost of capital is increasingly zero bound then mathematically speaking it is also impossible for companies to go bankrupt then you cannot be rewarded adequately enough for avoiding the company that goes bankrupt or picking better business.
However, we wouldn’t be active managers if we didn’t continue to believe that this is not the case in the long-run or that there is always a place for investors to be discerning or not paying too much for a security above its intrinsic value. To return to our metaphor from before, the true value of a good stock picker will become evident when the tide begins to go down. When that day comes it will pay to already have a portfolio that is prepared, if you will forgive to mixed metaphor, to ride out the inevitable storm.
Markets & Commentary
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.