Equity

Is value dead?

Value investing has consistently trailed the broader market in recent years, prompting some institutional investors to question its role in the portfolio.
July 2020

Luke Casey

BA (Hons), CFA, CAIA Product Specialist, Pyrford International

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Christopher Jenks

Client Portfolio Manager

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Once a famous style embraced by Warren Buffett, value investing has consistently trailed the broader market in recent years, prompting some institutional investors to question its role in the portfolio. In this edition of IQ, Luke Casey, Client Portfolio Manager at Pyrford International Ltd. and Christopher Jenks, Client Portfolio Manager, Disciplined Equity Team at BMO Global Asset Management, share their perspectives on where value is headed in 2020 – and beyond. 

A closer look at value investing

Christopher Jenks: Is value dead? As you can imagine, we’ve heard this question a lot. While it’s true that value has underperformed expectations in recent years, the simple answer is no – value is not dead. Remember the underlying principle of the style is that the price you pay for a stock matters. Academic research supports this principle, showing there are clear benefits from buying cheaper stocks over full market cycles. But like all styles of investing, there are down cycles. Our data shows that investors have continued buying into the highest priced equities on the market. In fact, research dating to the start of 2018 shows a majority of returns across the US equity market have been led by the most expensive 10% of companies. So, we don’t believe that value is dead, it’s simply in the midst of a down cycle.

Luke Casey: It’s easy to see why. A decade of low interest rates prolonged the bull market in which momentum and growth were dominating returns. Within that particular universe, you typically find high-flying companies with great stories behind them, which investors sometimes find so attractive that they forget they are overpaying for earnings or relying on future earnings growth to justify today’s high prices. There is also misperception that value focused managers are all looking for beaten up, turnaround projects, but that is not our niche at all. We look for high-quality companies, that is companies with low leverage and iron-clad fundamentals, which are trading at attractive valuations.   

CJ: Exactly. What we’ve experienced is a cyclical issue that appears structural. Central banks explicitly cut interest rates after the 2008 financial crisis in order to stimulate growth and investment in the economy. However, the unintended consequence was spread compression across the risk spectrum, which caused investors to unconsciously extrapolate current growth into far-fetched valuations. It’s textbook behavioral bias, amplified by the unique existence of a decade-long rally in equities, which has resulted in dislocations in equity markets that should provide an opportunity for alpha generation.

LC: At the end of 2019, virtually all quality stocks with sustainable earnings and achievable dividend targets were expensive. Only deep value was cheap, but that meant going toward financials and consumer discretionary – sectors where it would be challenging to find companies with solid earnings profiles. Since there were few names that could pair strong fundamentals with affordable valuations, we had to accept the majority of value plays were outside our mandate. At those times, you have to be patient in the knowledge that markets will ultimately correct – as they invariably do – even if you cannot accurately guess which economic drivers will drive valuations back on course.

Varying approaches to value investing

LC: This may sound like a politician’s answer, but there are truly multiple ways of assessing value. At one end of the spectrum are deep value managers, who hunt for turnaround situations, companies that trade below intrinsic value and sectors that are out of favor. We don’t fish in that area. We strive to build portfolios based on dividend yield and quality of earnings, which ultimately keeps us outside of the deep value part of the universe.

CJ: Meanwhile, our Chicago-based team takes a comprehensive approach to value. We look at both deep and relative approaches, focusing on three main themes: company fundamentals, valuation and investor sentiment. We really try to understand the margin profile, looking for companies that have consistent, repeatable growth patterns, strong balance sheets and a track record of responsibly allocating shareholder capital. Then we take a closer look at price considerations. And finally, we gauge the market’s interest by looking at signals which include price momentum, short interest and other such metrics. Adding this third step allows to separate the attractively valued investment opportunities from the stocks that are cheap for a reason.

LC: Agreed. It’s crucial to avoid “value traps” and “falling knives” by not overpaying for earnings. Strong value discipline means refusing to buy at outrageous premiums with the expectation that earnings will somehow grow into those multiples. We want to be more conservative and pragmatic, because ultimately our mindset is rooted in preserving client capital. During bull markets, there may be periods towards the end of a bull market where we lag behind the index; however, we feel confident in our core value approach for generating alpha through full market cycles.

CJ: One of our biggest competitive advantages is our proprietary dashboard called Market Monitor, which we developed to identify unusual relationships or dislocations in the market. We use it as a primary tool to position our portfolios, whether for the purposes of risk management or alpha generation. Its genesis goes back to the 2009 risk rally where we saw stocks bounce off the bottom of the financial crisis lows. That experience was an eye opener, instilling in us the need to be more nimble and dynamic in our approach.

Will COVID-19 be the tipping point?

LC: Part of our frustration with COVID-19 was that valuations didn’t come back as far as we would have liked. There were several stocks which we were close to pulling the trigger on, but the quality attributes which we found attractive worked against our interests. In effect, they sold off from being vastly overvalued to simply being overvalued. However, as the economic shutdown continues, there could be an opportunity to step in at a more reasonable price point, particularly if corporates revise down earnings forecasts.  

CJ: Interestingly, management guidance and analyst forecasts have been slow to react because of the uncertainty as to how the quarantine will impact equities. With the notable exception of tourism, restaurants and leisure industries, the market is struggling to pin down valuations. In fact, valuation spreads have widened from two standard deviations in February to three in March, suggesting that investors continued to bid up already expensive stocks. To inject some sanity, we started screening the universe of companies in our portfolio using a more expansive set of quality metrics – such as bond yields and option-adjusted spreads – looking to the fixed income markets for an early indication of default, earnings impairment or financial distress.

LC: There were a few exceptions though. Companies that could be perceived as vulnerable to the economic shutdown, but were in fact supported by strong fundamentals, became attractive. We initiated a position in an industrial conglomerate with ties to the airline industry because investors sold off based on its proximity to a hard-hit sector. We understood through our research that the company was well diversified from airlines, and could likely sustain its healthy margins now and beyond the crisis. We especially liked that one-third of its revenue came from recurring maintenance work, which should provide a stable base on which they can continue to build.

CJ: We also made additions to the portfolio. One name that comes to mind is Polaris, a leader in the recreational vehicle category. The company was grounded in excellent fundamentals, as evidenced by double digit revenue growth that far exceeded anything within that space from a competitive standpoint. When we saw their shares drop 50% as a result of COVID-19, we took action, and since the point of purchase the share price has approximately doubled in value.

Value: The road ahead

CJ: We’ve done a lot of work to understand how a potential recovery could favour different types of managers. What we found is the initial stages of a recovery will typically benefit deep value managers first, which is usually accompanied with a momentum correction. Then, as it matures and becomes more sustained, you see relative value catch up and losses from momentum stocks stabilize.

LC: It also depends what works for your clients and the role a manager with low downside protection could play. Unlike the standard global value index, we are significantly underweight financials to ensure the risk level is aligned with our quality objectives. In fact, we haven’t owned banks in certain economies for the past 10 years because of all the structural issues that surfaced during the Financial Crisis. A deep value manager would almost certainly have exposure to those stocks on the basis that they’re trading at less than their intrinsic value, but we prefer to invest in quality assets that benefit further down the road because it’s aligned with our stated goal of principal protection.

CJ: Prior to the pandemic, we had a number of optimistic data points for value. Specifically, valuation spreads – a metric from our dashboard which shows the separation between cheap and expensive stocks in the market relative to historical trends. The effects of COVID-19 have widened valuation spreads to three standard deviations, an extreme rivalling the likes of the Tech Bubble. This is a crucial indicator for the future return potential of value stocks. Think of an elastic band: when pulled, it snaps back. Likewise, the wider the valuation spread, the better the environment for value ahead.

For more valuable investment strategies, please contact your Regional BMO Asset Management Institutional Sales & Service Representative.

Disclosures

Not intended for distribution outside of Canada.

Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations.

This communication is intended for informational purposes only and is not, and should not be construed as, investment, legal or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Past performance does not guarantee future results.

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