US value: The case for defensive quality

28/05/2019

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As the equity market’s rally of over ten years has taken valuations to lofty levels and growth has significantly outperformed value, the question arises: “is value investing dead?” Recently, a research firm sent out a missive entitled ‘The Death of Value Continues’. This of course is music to our ears at Perkins and to anyone who believes in reversion to the mean. Despite the strength of growth equity investing today, we know for certain that value and growth investing are cyclical, and this cycle is particularly long in the tooth. When death cries abound it is the time to take a closer look at value. And for any investors concerned about market valuation today and market volatility in the future, ‘defensive value’ deserves, in our view, at least an allocation in a balanced portfolio.
 
As the chart below shows, despite the recent long run from growth and momentum investing, a value-oriented strategy has still outperformed over extended periods. This does not come without risks, however, which is why a defensive value strategy focused on finding high quality stocks is particularly important.
 
Chart 1: Growth has outperformed value globally since 2008


Source: Thomson Reuters DataStream, January 1975 to May 2019. Chart shows relative performance (%) of the MSCI World Growth Index vs the MSCI World Value Index. When the chart line goes down, Value as a style outperformed Growth. When the chart line rises, Growth outperformed Value.
 
An ageing growth cycle
 
Mean reversion is a powerful concept working in favour of value stocks now that growth is on a 10 year run. From 1987 through 2016, the average growth cycle lasted six quarters, with the longest cycle topping out at 12 quarters (1988–1991). During the same timeframe, the longest value cycle lasted 15 quarters from 2002–2006. Certainly, it is normal for the market to shift between cycles. Given how long the current growth-driven market has lasted and the normalisation of market volatility, we believe that we may soon revert to an environment in which value outperforms growth.
 
In addition, during periods of strong market upswings, investors shy away from value stocks and chase momentum plays, perceiving value to be perpetually out of favour. Such times generally cause the market to focus on shorter time horizons, without a sense for a more distant ‘tomorrow’. Today appears to be such a time.
 
Protecting against market corrections and overvaluation
 
While the long-term data makes us bullish on value strategies generally, we continue to have concern about both a market correction and overall market valuation. We identify these risks first and foremost from a bottom-up perspective by looking in aggregate at our reward to risk statistics on each individual stock we consider. Secondarily, we consider the portfolio from the top down by looking at market multiples. In fact, the Case-Shiller price/earnings (P/E) ratio has rarely looked more expensive over the last 100 years (chart 2).
 
Chart 2: Are PEs indicating that stocks are expensive?

Source: Shiller P/E, a cyclically adjusted price/earnings ratio dividing price by average of 10 years of earnings, adjusted for inflation. January 1881 to May 2019.
 
Our concerns about the market were only partially realised at the beginning and end of 2018, with two sudden and volatile sell-offs of 10.2% (26 January to 8 February, S&P 500 Composite Index) and 15.7% (3 December to 24 December), which ultimately proved to be short lived.
 
That said; we believe that while the economy appears strong today, corrections like these will eventually be longer in duration and more severe in magnitude. As a result, it is worth considering a defensive value strategy, which could provide critical downside protection during moments of greater market cyclicality. Generally speaking, during periods of heightened risk, a defensive investment strategy affords investors the opportunity to stay invested in the market while mitigating downside risk. It also protects against the tendency to try to ‘time the market’. Not all value investing styles are the same. Deep value investing often comes with significant risk and can lead investors into value traps. Our brand of quality value investing is a different and more risk-averse animal than our deep value peers.
 
Focusing on quality
 
While we believe that value stocks are poised for relatively strong performance, investors should not be complacent in their positioning. We generally believe that risks are directly correlated to market upswings, and generally get more distorted from a valuation perspective for high growth companies during periods of market ebullience. As a result, investors should consider the risks associated with both high quality stocks trading at peak valuations as well as the risk of lower quality stocks that are more susceptible to adverse developments over full market cycles. There are several ways to mitigate some of these risks while still owning high quality stocks.
 
Healthy balance sheets wanted
 
One major risk with many companies is leverage, which has increased across the market since the early noughties (see chart 3). Many companies have used easy monetary policy to increase leverage on their balance sheets. Companies have been able to access low-cost debt to engage in shareholder-friendly activities, such as stock buybacks and mergers and acquisitions. Some management teams have made smarter (ie, value enhancing) decisions than others, but corporate balance sheets are generally the worse for wear. We are concerned that some of these companies may have taken on more debt than they can comfortably service. And at this point in the business cycle – already extended by historical standards – it is especially concerning that many of these firms have not been diligent in deleveraging their balance sheets.
 
Chart 3: Leverage has increased in the Russell 3000 Index


Source: Jefferies Group, as at August 2018. Data shown represents net debt to earnings before interest, tax, depreciation and amortisation (EBITDA) for the Russell 3000 Index. Sectors are based on the Global Industry Classification Standard (GICS).
 
This debt creates a potentially dangerous dynamic. Until recently, the slow pace of economic recovery has been challenging for earnings growth, particularly in cases where a firm has significant cyclical and commodity exposure. An overly levered balanced sheet may compound an earnings miss and make it much harder for a company to recover. And if profit margins tighten from here, which seems likely as we are at record high margins today, high debt levels will squeeze companies’ free cash flow. Given these trends and where we are in the business cycle, we believe investments in well-capitalised and liquid balance sheets may serve investors better than over-encumbered alternatives.
 
Value trap avoidance
 
One of the biggest mistakes many value managers make is mistaking a low price for a good bargain. The two are often not the same. A defensive approach to value investing puts a significant premium on competitive advantage and investing in businesses that, while potentially challenged in the near term, have strong long-term prospects. We have written extensively on value trap avoidance in the past, and in short there are a variety of traps to avoid that we have spelled out in some detail in an earlier paper.
 
Diversified drivers of alpha
 
Additionally, we believe that less mainstream holdings, which we think of as ‘off the beaten path’ stocks, limit exposure to general market bullishness. Our research efforts increasingly direct us to stocks with either less Wall Street or sell-side analyst coverage, or those that are out of favour with the Street. We like management teams that are not overly promotional and who are good stewards of shareholder capital, and niche businesses with secular business drivers. In navigating today’s great bull market, we believe that the further a stock is from front-page headlines, the better. Investing with an all-cap mandate also allows us the opportunity to invest in small and mid-cap stocks that provide even further diversification of alpha, as well more off the beaten path companies.
 
The bottom line is that we favour an eclectic mix of holdings. A healthy mix of different drivers of alpha (ie, risk-adjusted performance) strengthens portfolios. Ultimately, as the market and many of its individual stock components become increasingly unattractive from a reward-to-risk standpoint, we want the portfolios that we manage to look less like the market.

Les opinions exprimées ici sont celles de l'auteur au moment de la publication du présent document et peuvent différer de celles d'autres collaborateurs/équipes de Janus Henderson Investors. Les références à des titres, fonds, secteurs et indices au sein du présent document ne sauraient être interprétées comme une offre ou une sollicitation d'achat ou de vente.

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