Following the outbreak of Covid-19 and significant falls in equity markets, we first started adding deep value stocks to our portfolios in April 2020 as we reacted to the indicators in our Cashflow Solution investment process. Eighteen months on and it seems sensible to pause and reflect on how well this has worked and, importantly, what we can expect over the next 18 months.
Our investment process was indeed ahead of the market and the indicators we use to tilt our portfolios towards either growth, quality or – in this case – value proved to be not only very timely but also very beneficial.
However, it would be wrong to say this has been an easy one-way bet. In fact, the outperformance of value over growth and quality in the last year – while significant – has been volatile. This has led many investors to question continually the essence and sustainability of the value rally. In times of strain and controversy, we always look at the empirical evidence. On this occasion, we take great reassurance from the fact that history is repeating itself.
Looking back at previous periods of value outperformance, we have noted that this journey is rarely smooth. In fact, if you look at the best three-year performance periods for value, these include some of the style’s worst monthly drawdowns. Our analysis of the data shows that if investors had held on to value during these short periods of underperformance, they were richly rewarded in subsequent months and years.
So where do we stand today and what are our indicators telling us? We know that valuation is a very important determinant of the future performance of an investment style. Given the many years of chronic underperformance, value as an investment style is still very cheap today. Meanwhile, at the other end of the valuation spectrum, quality growth – having enjoyed a buoyant decade-long run of outperformance – is looking very expensive.
While value has performed well over the last year or so, we are not complacent and remain mindful that in investment things never stay the same for too long. What do we mean by this and how is it relevant to the value or quality growth debate today?
Whereas traditional measures of value include a broad range of balance sheet asset ratios such as price-to-book and income statement measures such as the price/earnings ratios, our assessment of value is instead tethered to cash flows – a more relevant and accurate yardstick we believe of the value opportunity. In our investment process, we categorise value stocks into two categories: Contrarian Value and Recovering Value. We think the value story is transitioning from a fairly indiscriminate deep contrarian value rally that started more earnestly in Q4 2020 into what we would call a rally in recovering value. These are stocks that are still cheap and lowly appreciated by many investors but are beginning to show encouraging signs of recovering performance. This may be apparent in recent revenue or margin trends or, more subtly, in cash flow and balance sheet statements. We find the latter investments are typically very rewarding for investors as stock valuations rarely incorporate these data very quickly.
Furthermore, our analysis shows a huge dislocation in the valuation of recovering value stocks. The quintile of stocks possessing the best recovering value characteristics is very cheap by historic measures; in fact, according to our analysis, the scale of the investment opportunity is similar to that seen in the TMT bubble.
We have reflected this transition in the type of stock we are holding in our portfolios, selecting those with very high recovering value scores. These include car manufacturer Daimler, supplier of plumbing and heating systems for residential and commercial buildings Uponor, and three banks - Bank of Ireland, BNP Paribus and Societe Generale.
Meanwhile, the quintile of stocks scoring worst on our recovering value measure is very expensive by historic measures, highlighting the extreme re-rating some companies have enjoyed in recent years to a level well above their fundamental value. We can exploit this extreme valuation spread in our long-short fund by buying stocks in the top quintile and selling short stocks in the bottom quintile.
Another important development we have observed in our analysis recently has been in momentum and the type of stock that is now showing good momentum characteristics. Historic evidence shows that momentum can be a powerful indicator of performance. This means that in addition to selecting stocks with good recovering value scores, we are keen to ensure that our final stock selections are increasingly also showing good momentum characteristics.
Finally, and staying with the theme of momentum, it is significant to note some recent developments with regards to bond yields. We know that value correlates well with bond yields and that rising bond yields tend to be a headwind for longer duration stocks such as growth and quality. Yields are rising and now have good momentum. This should be a further supportive factor for the future performance of value stocks.
In conclusion, we think rising bond yields, a compelling valuation and the emergence of stocks with attractive recovering value scores and good momentum characteristics all bode well for the future returns for value and for funds with this type of exposure.
Key Risks
