Back in December 2018, I wrote an article asking whether it was a good time for pension plan sponsors to revisit value investing. At that time, public equity markets were having a difficult quarter and traditional value strategies didn’t perform as well as expected, failing to provide the much-touted protection in down equity markets.
Flash forward to March and April 2020 and it seems that traditional value strategies experienced a similar fate, with many value equity strategies underperforming their relevant index. Given the performance of value strategies over the past few years, it seems prudent to ask the question: Is value investing still relevant.
As a reminder, value managers seek to find stocks trading below their intrinsic value, whereas growth managers are willing to pay a bit more for a company that can deliver above trend growth and profit. I noted in the aforementioned article that valuation alone was no longer sufficient and that a quality screen needed to be applied as well when evaluating companies. Cheap securities don’t always translate into longer-term value creation and, in some cases, can lead to a value trap.
In the period between 2005 and 2015, leadership between growth and value investing approaches traded back and forth (as measured by the MSCI World index), with the performance gap staying in the five per cent range for the most part. Two exceptions occurred between 2006 and 2008, where value outperformed growth by approximately 10 per cent in the 2006/07 period and in the period leading up to the global financial crisis in 2007/08, where growth outperformed value by as much as 20 per cent.
Since 2017, growth has almost consistently outperformed value by about 10 per cent and, more recently, by as much as 30 per cent (one year trailing as at March 31, 2020). This has been driven by companies included in the information technology sector and, to a lesser degree, companies classified as health care and consumer discretionary. The worst performing sectors over the same time period have been real estate, financials and energy and, to a lesser degree, industrials.
When value investing was first applied, many of the publicly listed companies produced goods and therefore had capital assets and inventory as a starting point for valuation. As most developed countries have become wealthier and their labour and capital costs have increased, more and more of their publicly listed and traded companies have shifted to ideas and services, with production moving to lower-cost countries. Idea and service companies (Amazon.com Inc., Mastercard Inc. and Uber Technologies, Inc., for example) are not capital-intensive businesses and, therefore, one of the traditional valuation metrics, price to book, is less useful in determining intrinsic value.
Another metric often cited is price/earnings ratio. Value investors seek companies with below market P/E ratios. Over the past few years, companies that have been rewarded by investors have had relatively high P/E ratios, but have also delivered accelerating profits (and hence increased share price). Of course, low interest rates have led to rich valuations and this trend will likely continue for some time given guidance from the U.S. Federal Reserve.
Traditional value managers have therefore been concentrating their portfolios in a narrower range of sectors given their approach to evaluating companies and constructing portfolios. In Canada, according to data from eVestment and Eckler Ltd., this has led to the best performing institutional Canadian equity managers having a predominantly core or growth at a reasonable price investment approach over the past five years ending June 30, 2020.
And during that period between 2015-2020, only one value manager is included in the top 10, where eight of the 10 worst performing managers have been value managers. The statistics are similar for global equity managers, where eight out of 10 of the worst performing funds employ a value investing approach and 10 out of 10 of the best performing funds employ a growth investing approach.
Another trend over the past decade is a move towards more companies choosing to remain or go private, given the increased reporting requirements post-global financial crisis and the impact on strategic planning of the quarterly reporting cycle. We have certainly witnessed this trend in Canada where increasingly we see companies dropping out of the TSX composite index upon acquisition.
Anecdotally, it’s said that the balance has moved to a greater portion of gross domestic product being generated by private companies now than in the past (closer to 60 per cent now as opposed to 50 per cent in the past). So not only can value investing produce a sector bias, but it’s also limited even further by the pool of available investments.
So where do we go from here? Clearly, investors need to understand the benefits and limitations of value investing given the current market composition and investment climate. Where value investing is employed also employing a quality lens is important. Investors should also understand what sort of return pattern they’d like to experience since value investing can often lead to significant periods of out and underperformance. If any of the limitations noted above cause concern, it may be time to review your equity investment structure.