When will the value bear market end?
People often ask us what investment style is Ophir Asset Management? We respond we are style agnostic, if we believe there is money to be made buying a company that is growing significantly we will invest in it. Likewise, if we believe there is an unloved company that will see considerable price appreciation in the near term, we will invest in that too. It should be said historically we have generated most of our returns by identifying under-appreciated companies that can reinvest their cash flow and grow to be big companies in the future. There is nothing more satisfying than finding a small company and watching it progress to one day become a household name big cap company.
In recent years investors who have owned a portfolio of only value stocks have experienced severe pain. In fact being overweight value stocks and underweight growth stocks has now lost money for 5 out of the last 6 years on the Australian equity market. The story is even more grim in the US, with value underperforming for the last 12 years! Not surprisingly the woeful performance of value stocks is leading many to speculate that value investing is dead!
Although we are not quite as willing to put a nail in the value coffin, we too have been surprised that value stocks just keep remaining, well cheap. Meanwhile high flying growth stocks, especially technology related stocks, keep racing ahead. But could we be on the cusp of a regime change, where investors’ willingness to pay up for growth stocks wanes, and value stocks stage a fightback?
Performance of Australian Value Stocks Minus Growth Stocks
Who are value investors?
Before we answer that question, let’s take a step back and remind ourselves exactly who are value investors. Traditionally, value investors have been defined as those with low expectations who seek out investments amongst stocks that are out of favour. These bargain hunters believe that most investors in the market are overly pessimistic on many companies, and that those stocks will see their share prices shoot higher once other investors realises their mistake!
For a long time, value investors were portrayed as the serious and considered investors, while growth investors were painted as a naive group, who often proclaimed “it's different this time”, or simply fell in love with certain companies without having any concept of the stock’s intrinsic value. Value investors by contrast rolled up their sleeves, and searched for companies whose share prices were selling at below the worth of their assets, or below the value of future growth prospects. At face value this sounds like a sensible investment strategy, right? If so, then why has value been such an underperformer for so long?
Why have value investors underperformed?
The reason for value investing’s underperformance is heavily debated, but appears to be in large part because growth stocks have so far avoided the eventual disappointment which it was thought would inevitably come.
Historically, growth stocks have been priced to keep delivering an unrealistically high level of earnings growth. When the market woke up to the fact that profit growth would not be able to match those expectations, their share prices collapsed. The late 1990’s tech bubble implosion sits as a textbook example of exactly this.
Performance of US Value Stocks Minus Growth Stocks
In this cycle however, growth stocks haven’t just met the high expectation which investors placed on them, they’ve actually exceeded them! Globally, the most high profile examples of this trend have been big tech names such as Apple, Facebook and Alphabet. The story has not just been confined to tech names however, but has been playing out through multiple sectors, that is the strong companies have grown stronger, and value investors missed out on them.
Warning signs to look for that the cycle is changing
Timing market cycles is a notoriously difficult, and risky, exercise. And the stock markets history is littered with periods where a certain style of investing outperforms for what seems an eternity, only to collapse abruptly. Being invested on the wrong side of the inevitable rotation from growth stocks back to value stocks would be a painful experience. To protect against this risk, we’ve prepared a three point checklist of warning signs.
1. At the top of this list would be a meaningful move up in interest rates. With the valuation of growth stocks heavily weighted towards earnings far out into the future (often referred to as ‘duration’), higher interest rates would render the present value of these cashflows downwards, and hence share prices would be de-rated accordingly.
2. The next flag would be a recovery, or sharp pick-up, in economic growth. This may sound contradictory, as intuitively one could assume that growth stocks feed off a stronger economy. In reality this is not quite the case, as although growth stocks perform well in absolute terms when the economic outlook is being upgraded, value stocks do even better. Essentially when the economy heats up, the unique stories of growth stocks are no longer as highly prized or sought after.
3. Our final warning sign would be that the valuation gap between value and growth stocks becomes so wide, that it just collapses under the weight of its own unsustainability. Versus the previous two flags, this strategy runs the risk of being wrong for potentially a long time before it finally becomes right. Sydney house prices could be thought of as a similar such story, where their overvaluation seems obvious now they are falling in price. However, through the years when property prices kept rising, betting against them seemed frustrating, futile and for some painful.
Our forward looking view
Looking ahead through 2019, growth rates in Australian and offshore don’t look set to stage any meaningful acceleration, and hence value stocks won’t find support from this driver. Interest rates seem equally unlikely to cause damage to growth equities, particularly so given inflation pressures are almost non-existent through the developed world.
To us, the most likely scenario which ends this value bear market is not through any one specific catalyst, but instead just a change in sentiment from the market. Investors will inevitably reach a point where they see the gap in prices between value stocks and growth stocks as too wide, and unsustainable, and that they need to converge. The reversal of Melbourne and Sydney house prices over the last 18 months serves as a perfect illustration of how a directional change can occur, even without a specific catalyst. For years we were told that without interest rate hikes from the Reserve Bank, or a domestic recession, house prices wouldn’t fall. But they are, and that’s because both buyers and sellers are re-assessing while credit availability gets harder.
Importantly Ophir is style agnostic. We always own some ‘growth’ stocks, some ‘value’ stocks and some that are somewhere in between. We also place close attention to valuation, looking at all companies alongside each other making sure we are not overpaying for any specific stock. They key question we ask ourselves with any stock in our portfolio that has gone up a lot is ‘if we saw this company today for the first time would we buy it at this price?’. If the answer is no, because it is too expensive, then we will sell it. It is a great discipline to have and ensures the portfolio never just owns stocks because they are ‘going up’.
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Andrew has over 15 years’ experience in portfolio management of listed companies, stockbroking and economic analysis. Prior to co-founding Ophir, Andrew worked from 2007 to 2011 as a portfolio manager at Paradice Investment Management.