Advisers take note: cheap is not always nasty
If you needed evidence to support that the United States’ Magnificent Seven tech shares are finally out of favour, you would have found it in spades at the 2025 Investment Forum gathering at Sun City. The financial advisers and other investment professionals in attendance were fed a programme dominated by income and value focused fund managers.
The paradox of choice
One of your writer’s favourite value style presentations was dished up by Lyrical Asset Management’s senior MD, David Merklin, introduced by Ray Mhere, CEO of Curate Investments. Curate, a newcomer to the South African asset management space, has appointed Lyrical to run its Global Value Fund. “It is no surprise that this event is themed: Paradox of Choice,” said Mhere during his opening comment. He said advisers and investors faced the daunting task of structuring portfolios from almost 2000 unit trusts locally, and over 150000 globally.
Merklin wasted little time giving the value style a punt, calling it the most enduring source of alpha in the market. He used a 50-year chart of historic market returns to position the cheapest 20% of the market versus the MSCIA World and MSCI World Value indices. Any guesses what this chart showed? Yes, dear reader, if you had invested a thousand dollars into each of these baskets back in 1975, you would be sitting on around USD130 000,00 from the MSCI indices today, or a staggering USD1.6 million from your ‘cheapest quintile’ exposure. Put another way, the cheap shares’ average annual return was 5.5% higher than the best of the indices over 50-years.
The cheapest section of the world equity market endures through the cycles, outperforming handsomely during the value ‘up cycle’ but shaking investors’ faith during the “quite unpleasant” underperformance recorded during the value ‘down cycle’. “The value up cycles last 9.4 years on average while the down cycles last two years; but we do not have to avoid these down cycles because we know we will make 5.5% per annum more than the market if we just sit through them,” Merklin said. His fund’s average holding period is around 7.5 years.
The value index dilemma
The presenter conceded that the MSCI Value index was not much of a proxy for the value style. This stems from an anomaly when the indices were established, resulting in around 1000 of the 1300 MSCI World shares being pulled into the value index. That’s good news for active managers because you cannot get exposure to the benefits of value investing by simply investing in a passive MSCI Value index. “There is no passive index for the cheapest 20% of stocks,” Merklin said.
Continuing on the value cycle track, the 50-year charts reveal that the deeper the down cycle underperformance, the bigger the ensuing up cycle outperformance. The shallowest value stock underperformance occurred following the 2008-9 Global Financial Crisis, with a mere 8.8% lag, followed by a 219% outperformance over the following years. In contrast, the worst down cycle for value occurred during the tech bubble, followed by a 317% outperformance.
This trend repeated between 2017 and 2020, the second worst value down cycle in the last five decades, an underperformance of 31.4%. “The cheapest quintile stocks have been outperforming since the middle of 2020, but only by about 28% … we have a tremendous amount of value up cycle ahead of us in the next few years,” Merklin said. He noted we were only four years into a cycle that lasted, on average, close to a decade.
Another development playing into the hands of value style investors is that the cheapest 20% of global stocks are trading at a steep discount to the market, based on the price-to-earnings (PE) measure. “The market is trading at a 105% premium to the cheapest 20% of stocks at present, an incredible number [given that] the normal range is 30-40%,” the presenter said. Wow. Value investing started to sound like a sure thing. Perhaps; but it is really difficult to find the gems amidst the junk that litters this part of the market.
Leave it to the experts
In fact, without expert fund managers, you would be hard-pressed to get your clients invested in the right value opportunities. Lyrical relies on three criteria for investing namely value, quality, and analysability. The value requirement is met by applying a screen to identify the 500-odd cheapest stocks among the 1000 largest US and 1500 largest non-US global stocks.
Quality is then assessed based on return on investor capital (ROIC) and consistency of earnings growth; the former having a hurdle of at least 10% per annum. Merklin pointed out that the ROIC hurdle immediately ruled out airline and mining stocks. So, from a list of 500 cheap stocks, the asset manager deletes stocks in the airlines and mining sectors, before moving on to the third factor.
“Analysability is about simplicity,” the presenter said. “We only want to buy businesses that are simple enough to analyse and understand ... we want to be fully aware of what the business does.” This requirement rules out bank and pharmaceutical shares; the former because it is difficult to ‘see through’ a bank’s loan book, and the latter because the future earnings of pharmaceutical firms are hidden in ‘secret’ drug pipelines. Your clients should also be wary of cheap retail businesses whose revenues are under threat from Amazon.
“We end up with a group of really cheap stocks that are [presently] trading at 11 times the next 12 months earnings versus the MSCI World at 19.1 and the MSCI Value at 15,” Merklin said. “This is a really cheap portfolio at a 40% discount to the market.” He dispelled allegations that this portfolio was ‘junk’ by drawing attention to the earnings track record of its quality, cheap shares.
Overall, his portfolio offers 8.8% annual earnings growth versus 5.5% from the MSCI world. Hence, his marketing pitch: “We have been able to buy a portfolio of stocks that are growing faster than the market, but are trading at a 40% discount to the market.”
Wait: value AND growth?
The irony here is that a sensible screening of cheap shares yields a value and growth portfolio. The presentation offered three examples of individual stock successes. First, Ameriprise Financial (NYSE: AMP), a business with around 9700 financial advisers working for them, managing the wealth of two million Americans. This business is cheap (12 times forward PE) and offers quality, with earnings growing at 15.5% per annum. It is cheap because too many investors, active managers included, are looking for a catalyst for short-term price moves.
“We care about the long term. We see a cheap, quality, simple business and we buy it … and we have held this stock for over 15 years,” Merklin said. And you can stay invested in this type of share for years whether or not it delivers that much-hyped multiple expansion. Multiple expansion occurs when the market positively rerates a share and buyers chase the price much higher, pushing the PE ratio higher too. Another Lyrical stock illustrates the multiple expansion principle in action.
The fund bought a firm called Adago Technologies back in 2013. At the time, the share traded on about 12 times earnings, at around USD3,00 per share. Adago became Broadcom Inc. (NASDAQ: AVGO) following a major acquisition and rebranding in 2016, and is trading at close to USD200,00 per share today. The firm’s prospects changed once investors perceived it to be an artificial intelligence (AI) play, early 2024. “It took 10 years and seven months, but we did get our multiple expansion on this share, and we made 2963% on it,” Merklin said.
Resilience for market-beating returns
A final consideration is to find resilient businesses that can withstand shocks in a competitive environment. If you want to help your clients lock in excellent equity returns, then you best leave the style-related decision making and stock picking to the experts. The value methodology featured in today’s newsletter is generating market-beating returns by buying good quality, analysable stocks from the cheapest part of the global market.
Writer’s thoughts:
Value investing rewards patience, but not all your clients have it. How do you keep your clients committed to a share selection methodology when short-term gains continually tempt them away? Please comment below, interact with us on X at @fanews_online or email us your thoughts [email protected].
