llan Chaitowitz considers the time to buy into classic value strategies and what drives value trends.
This year, equities experienced the sharpest collapse in history as the Covid-19 pandemic made many panic and try to preserve capital. In fact, such extremes of market sentiment are often fertile conditions for capital deployment, with the richest returns for those willing and able to swim against the tide. But with threats of a both a second wave, along with prolonged economic weakness, where should investors places their bets now? In companies that have been hit hardest by the disruption, or those that can continue to grow despite it?
Over the last five years, investors following the classic value style, which involves the purchase of the most beaten-up stocks, would have delivered anaemic returns. The MSCI World Value Index has underperformed its growth equivalent by 8% per year. After such a long period of weakness, canny readers may well be thinking: is now the time to buy into classic value strategies? To answer this, we need a better understanding of what has driven the trend.
Conventional wisdom has tied it to seemingly ever-lower long-term interest rates, which has kept the weakest businesses solvent and thus stopped the traditional capital cycle from buoying the strongest. Typically, a rebound in the cost of funding would hurt most those businesses with the weakest profitability and see them either folding or acquired by more resilient peers. This process is known as the capital cycle and can be applied to industries as diverse as oil field drillers, mortgage lenders and widget manufacturers.
Historically, value investors have relied on this process of “creative destruction”, a term first coined by the economist Joseph Schumpeter in 1942. By buying very beaten-up capital-intensive businesses somewhere close to the bottom of the cycle, experienced investors could reap the rewards of the rebound as these industries recover and valuations mean revert. But there are good reasons to question whether an inflection in the performance of value is imminent any time soon.
Critically, the environment of low interest rates shows no sign of abating and has recently been surprising to the downside. This has enabled firms that are insolvent to persist and crowd out growth opportunities for more productive firms. According to the Organisation for Economic Cooperation and Development, such “zombie firms” saw their share of total firm count double over the 10 years following the great financial crisis.
So if a persistently low interest rate environment has kept fragile businesses on life support, what has kept long-term interest rates surprising to the downside? One main contributor is population demographics as the baby boomer generation enters retirement age. Elderly people are typically less productive and require more social support in terms of healthcare. Higher dependency ratios across developed countries and China are set to weigh on growth over the next decade. So buying value here seems to require a prophetic insight into interest rates when the broader market maintains a decidedly muted outlook. Indeed, at the time of writing the value of negative yielding debt has exceeded $15 trillion.
Other readers may be tempted to follow the trend and stick with growth stocks. Technology disruptors, such as Amazon and Netflix, seem capable of strong growth regardless of the macroeconomic backdrop. Indeed, they are beneficiaries of other strong secular drivers, such as the shift to online retail.
But for this strategy to work requires those same trends to persist at a time when the valuation discrepancy between classic value and growth is the highest it’s been since the dotcom bubble of 2000! Yet today’s technology disruptors are likely to face an erosion of future returns as their own capital cycle plays out. The problem with growth stocks is that at current prices many may exceed the net present value of their expected future cash flows. Furthermore, even the most seasoned investors find timing the peaks and troughs of macroeconomic cycles challenging. If, for any reason, the global economic outlook improves, these shares could underperform markedly. So while the powerful secular trends weighing on global growth look set to continue for many years to come, buying growth today is an exercise in swapping economic cycle risk with valuation risk.
So, where should risk-averse equity investors place their bets? My own approach to investing takes an agnostic view of growth and rather focuses on the underlying quality of a business. High-quality companies do something differently, consistently well, that is hard to copy. They can typically sustain their returns for longer than the market appreciates and are less likely to suffer irreversible declines in profitability. The best of these have attractive business opportunities in which to reinvest their profits, which makes the business’ scale, and gains for shareholders, compound over time. A selection of the world’s best companies purchased at attractive valuations should stay in rude health regardless of the economic backdrop.
llan Chaitowitz is co-manager of the Nomura Global High Conviction Fund.