Is value investing ripe for a comeback? How many times has the style been written-off before, only to bounce back and confound its critics. But now, after lagging growth for years, even the most ardent fans of value seem unnerved. Recently, several high profile star managers have retired after struggling for a period to perform with value. Might this be the signal of maximum pessimism? A point at which value investors should be patient till the pendulum swings back?
Certainly, there are signs that it might be different this time. If value needs a tailwind, it is surely inflation. That can bail out ailing businesses and devalue debt. In that environment, price generally beats quality. And it would surely trigger a steepening of the yield curve, posing a challenge for highly valued growth businesses, priced much like bonds. In time, everyone's psychology changes. This year we have seen some months where value has sprung into life, funded by profit-taking from growth stocks. The potential for a sharp stockmarket rotation seems to be bubbling under.
The problem for investors is defining value. At a stock level some metrics help, such as ratios of market value and assets or cash flows. But in the hands of an investment manager ‘value’ too often becomes a narrative. The word carries so much emotion. Prudent, rational, contrarian all come to mind. Value’s appeal is heartfelt: it is human nature to admire the principled and heroic qualities of its proponents. The term itself can attract investors as a brand. But it can mean that value managers and their track records escape detailed scrutiny. What is the catalyst in a value stock that would make investors re-rate it? Cynics note that it is usually easier for active managers to beat an out-of-favour style, as indeed it can be hard to underperform an in-favour one. Clients need to check that value is not just a performance story.
Little is understood of the driving forces for low growth and stable prices. Technology, global competition, excess savings and lack of business investment have all been offered as explanations. It has brought relentless challenge for value investing as older legacy business models face continued cost pressures and disruption; whether on the high street, banks, or heavy industry. ‘Cheap’ shares amongst these traditional businesses have often proved value-traps.
The pandemic is by itself disinflationary, reducing demand and encouraging those who have maintained earnings to save more and rebuild their savings against future uncertainty. More unemployment may lie ahead until new businesses are established, and this also depresses consumer demand and economic activity. Some employers have found that flexible and remote working offers scope for efficiency improvement and hiring staff from further afield. It seems the forces holding back prices are still in place.
But, central banks have renewed determination to risk higher inflation. It always seems an easy way out of excess debt even though it may actually discourage the enterprise and economic renewal that is needed now. Already, there are signs of physical constraints on some goods and assets. Anyone currently buying a car or moving house will have seen the strong demand and pricing in these sectors. And this overheating has extended into industrial areas where activity is harder to scale-up. There may be no respite for banks, oil majors and high street retailers, but some basic industries and specialist industrial materials are pushing up prices. This is happening at a time when many manufacturers are deciding to shorten supply chains, recognising there may be more challenge in moving essential parts around the world.
There may be value in the traditional areas. Legacy businesses will not stand still and not all will be disrupted out of existence. Management are responding and assets will be re-deployed. Already oil companies plan to transform themselves to provide more sustainable energy and some retailers are building new online delivery capability. Many supermarkets are busy developing parts of their car parks into blocks of flats. Value investing should be about spotting change that others miss.
The rotation from value to growth has been extreme; ahead may lie a more balanced economy with at least pockets of inflation. This might turn into a better environment for value.
A version of this article was published on Citywire on 28/10/2020.