Cheap stocks aren't the reason value is winning

Investors trying to make sense of today’s AI-led market often compare it to the dot-com boom. Dr David Walsh, Head of Investments at RQI Investors, says the comparison holds in some ways but not others.

The dot-com era was built on telecom, fibre and software platforms, and “anything with dot-com in its name ran very strongly”. (We all know how that ended.)

Today’s leaders are a small group of companies in semiconductors, data centres and hyperscalers, and they are building infrastructure that is driving much of the market’s growth. Walsh says the mindset behind the pricing is what looks familiar.

“The market is different in the sense that the construction of underlying stocks and what they’re doing is different, but the hubris is still very similar. It feels like a bubble. Expectations are extrapolating far too far into the future.”

He expects value and quant strategies to keep benefiting as that optimism fades. In the interview above, we discuss why value has been outperforming, how RQI’s quant model steers clear of value traps, and the market conditions that could work against the strategy.

Ignoring price on purpose

The RQI Global Value - Class A holds about half the tech weighting of the global index and is well underweight North America. Walsh says neither position is a view on the market. Both come from how the portfolio is built - companies are weighted by economic size, such as sales, earnings and assets, rather than by market value.

“By ignoring price, it tends to mean that we’re going to be underweight companies which are expensive.”

Samsung Electronics (KRX: 005930), one of the fund’s biggest contributors this year, shows how this plays out. Samsung has been a large business for a long time, so it was already a big holding before the semiconductor rally. “In some sense, the market’s been catching up to that,” Walsh says. The share price has since risen past its economic weight, and the fund is now underweight.

The fund has been underweight SK Hynix throughout, even though it runs a similar business. “In fact, it’s only got a couple of years really performing very well, so it doesn’t have that economic size that we’d normally measure.”

What’s actually driving value’s run

RQI has run its Australian value strategy for institutional and wholesale clients since about 2008. In November, the strategy opens to retail investors for the first time through the RQI Australian Value Active ETF (ASX: RQAV).

The strategy finished the past year well ahead of the ASX 200, and Walsh says that wasn’t because cheap stocks rallied.

“That’s been driven largely by the fact that expensive stocks have underperformed rather than value stocks doing really, really well.”

This happened even though conditions worked against part of RQI’s process. From around August last year to early this year, low-quality stocks beat high-quality ones in what Walsh calls a “junk rally”. RQI’s quality tilt was flat over that time, momentum was slightly positive, and the core value exposure delivered most of the outperformance.

RQI scores quality on three measures:

• Profitability: the company’s long-term profit record and expected future profits.
• Management: for example, issuing too much capital, poor corporate culture or a lack of board diversity.
• External risk: for example, high default risk or a large build-up of goodwill.

The model leans away from low scorers within the value universe.

“If we can be underweight poor quality names in the value universe, it gives us a natural tailwind because we’re avoiding what have become known as value traps."

A falling share price doesn’t make a stock cheap

Walsh stresses the firm is not in the business of picking individual stocks. Even so, two ASX names show how the model treats a fallen share price.

Treasury Wine Estates (ASX: TWE) fell sharply between late last year and around March, and RQI was underweight through that fall. The stock has rebounded since the company restructured, but the model hasn’t changed its view.

“Its quality still looks poor, its momentum looks poor, its rebound is really more of a relief rally than underlying alpha stories.”

WiseTech (ASX: WTC)  is the second example. “We’re underweight the stock, it doesn’t look cheap even though it’s fallen a long way, but our alpha signals are still very negative on that stock.”

For the Australian strategy, the model covers “50 or 60 individual pieces of insight across 300-plus names”. It combines value with quality, momentum, sentiment and peer-relative signals. The aim is to spread risk across many small bets so the result doesn’t hinge on any one factor or stock.

Walsh sees that breadth as part of the case for the ETF. He suggests it can work as a core holding, as a counterweight in portfolios heavy in growth or momentum stocks, or as a diversifier, because weighting by economic size gives a broader portfolio than a cap-weighted index. He notes that concentration is less of a problem in Australia than in offshore markets.

When this approach struggles

Walsh’s team has said the past few years have been unusually good for quant, and future returns may look more normal. He identifies two conditions where the strategy can lag.

The first is a junk rally, where value can still do well but the quality tilt holds performance back. 

The second is the bigger risk, and it usually follows a sharp sell-off, when investors pay up for safety and stability whatever the price.

“So not so much a junk rally, the opposite - a quality rally that’s ignorant of price. That’s more of a period when value would underperform, but that is usually preceded by a significant selloff in the markets.”

When spring turns to summer

Walsh thinks quant can keep performing for some time, moving “from spring to summer”. The thing he’s watching most closely sits outside his model. “The next few years, I’m concerned about AI capex,” he says.

He doubts the AI build-out will earn an adequate return on the capital going into it. In his view, that means higher risk, higher borrowing costs and more leverage. He isn’t questioning the technology itself.

“AI is going to be a strong driver of economic growth and technological change and productivity growth in the future, but looks overpriced.”

His base case is that the AI bubble deflates rather than bursts, and growth stocks underperform. 

“In an environment when inflation looks higher and growth is lower, that’s a very good sweet spot for value and for quant investing.”

RQI Australian Value Active ETF now live

The RQI Australian Value Active ETF (ASX:RQAV) brings RQI Investors’ active quantitative approach to Australian value investing, now available on the ASX. Find out more.