Many institutional investors include value-oriented equity strategies in their portfolio to provide protection during declining equity markets. But not all value strategies are created equal, as many found out during the global financial crisis 10 years ago.
As well, many investors expected their portfolios to perform better than the broader market, to preserve cash, but this wasn’t always the case. We learned more about quality investing and value traps during that period, which contributed to differing results among value managers. For example, those that invested heavily in bank stocks — normally considered safe investments — during the financial crisis saw the value of these stocks decline sharply as the companies’ balance sheets were highly levered. And purchasing more of these cheap stocks only exacerbated the losses.
Given the difficult equity markets of the past few months, it seems like a good time to revisit value investing. At its most basic level, value investing is buying securities on sale or below their intrinsic value. As the theory goes, if you can buy something for less than it would normally cost you, with a margin of safety, you should make money. Of course, the difficult part is analyzing the intrinsic value of the security. But assuming you can buy the security for 30 to 50 per cent less than it would usually cost, you should achieve a healthy return.
Another key determinant is time horizon. Value investors tend to be patient, expecting to wait three to five years for their price target to be achieved. The longer the expected time horizon to achieve the desired price target, the larger the margin of safety or discount required. Value managers have often avoided investment in more cyclical companies, since the quality of their earnings varies and can be hard to project, depending on where we are in the economic cycle.
Value investors also tend to have an independent streak, buying what’s out of favour. Their portfolios will look quite different than the index, and often, their results involve high tracking errors versus the index, though this often translates into lower than market volatility over longer periods.
Going back to the bank example during the financial crisis, some investors forgot that capital preservation often requires the purchase of quality companies. In 1973, investment advisor Benjamin Graham wrote in his book, The Intelligent Investor:
“The risk of paying too high a price for good quality stocks — while a real one — is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions. The purchasers view the current good earnings as equivalent to ‘earning power’ and assume that prosperity is synonymous with safety. It is in those years that bonds and preferred stocks of inferior grade can be sold to the public at par, because they carry a little higher income return or a deceptively attractive conversion privilege. It is then, also, that common stocks of obscure companies can be floated at prices far above the tangible investment, on the strength of two or three years of excellent growth. These securities do not offer an adequate margin of safety in any admissible sense of the term.”
The strategies that seem to perform the best in times of market distress involve an element of quality — balance sheet quality, earnings quality, information transparency and corporate governance quality.
Quality companies share a number of traits: they tend to be leaders in their market (product or services) and operate in markets with growth potential; their businesses either offer attractive cashflows and dividends or reinvest in expanding their market and product/service footprint; they’re able to do this because they have a solid balance sheet, are profitable and demonstrate financial momentum; the company valuation is attractive based on a high discounted cashflow, low price-earnings ratio and price-book ratio (though this is less relevant for service companies); and quality companies are good corporate citizens with strong, stable leadership and management.
Until the market correction of the past couple of months, growth investing had been performing significantly better than value investing in the United States, with one of the widest differentials we’ve seen in years. For the year ending June 30, 2018, growth investing outperformed value investing by more than 11 per cent. By the end of September, this had narrowed to seven per cent.
It’s much more difficult to categorize growth and value stocks in Canada. At the end of June 2018, value investing was the better performer, since many energy and material stocks were classified as value. With the more recent decline in oil prices and financial services’ constrained stock performances, there’s very little difference in the performance of the MSCI global value and MSCI growth indexes, and hence the broader index.
Based on the above, it seems that owning quality companies in sectors with a competitive advantage, pricing power and good management is the place to be for equity investors, at least at this point in the cycle. And if they can buy these with a margin of safety, all the better.