Has Value’s time returned?
Andrew Dittberner, a senior investment manager at Cannon Asset Managers, looks at how the investment cycle has turned and sounds a warning for those following the growth style (whether knowingly or unwittingly)
For the last few years, growth investing has dominated the South African investment landscape resulting in the near abandonment of the value investment style by both investors and almost all investment managers alike. Last year we explored this trend and highlighted the incredible opportunities that the market’s aversion to value was creating.
Over the last six months, however, we have started to see some reversal of the above trend and so pose the question: Where are we in the style cycle? Is this the early part of a shift from growth to value? If so, then investors who have benefited over the last few years because of a bias to growth stocks will have to rethink their strategy, especially if they are unaware of this bias. Importantly, they will need to ensure that where they believe they have exposure to value, their underlying portfolios actually contain value opportunities, given the high level of style drift we have observed in the industry.
Our analysis suggests that while the last few years have had a strong bias towards growth, what we are observing in the market is less about the start of the value cycle, but rather about the end of growth outperforming. For example, most of the stocks that did well last year were incredibly expensive by our measures (hence growth stocks), whereas this year, stocks that have been performing well have been more evenly spread across the valuation spectrum.
One of the key valuation tools we use for asset allocation, as well as sector and stock analysis is the Cyclically Adjusted Price Earnings (CAPE) ratio. While one-year trailing price earnings ratios (PEs) are a good measure of value, we believe the CAPE ratio even better reflects a company’s underlying value. This is because the CAPE ratio uses seven years’ inflation adjusted, or through-the-cycle, earnings of a company in the denominator of the PE multiple. In so doing, the CAPE ratio removes the noise (short term earnings volatility) of one-year earnings in evaluating a company. It rather uses the “DNA” earnings stream of the business to value it, relative to the price you pay for the through-the-cycle earnings stream.
In this analysis, we break the market into quintiles. In terms of valuations (CAPE ratios), Quintile 1 represents the most attractive or low CAPE shares (Q1), up to Quintile 5 (Q5) which are the most expensive or high CAPE shares (CAPE Q5). Furthermore, we also binned shares into quintiles based on performance. Quintile 5 (Q5) represents the best performing shares and Quintile 1 (Q1) holds the worst performers.
In 2011, 57% of stocks in CAPE Q5 were in Q5 or Q4 in terms of performance. The majority of expensive shares performed above average last year. In 2012, of the most expensive shares (CAPE Q5), only 33% were in Q5 or Q4 based on performance. High CAPE shares are no longer leading the charge in terms of performance. Put differently, of the top performing shares (Q5), only 35% of them come from Q4 or Q5 based on CAPE ratios.
Figure 1: Valuations within the performance quintiles
(Click on image to enlarge)
Figure 1 separates the market into the performance quintiles (horizontal axis), and then plots the average CAPE quintile that comprises the respective performance quintiles. Since quintiles range from 1 to 5, the average is 3, and therefore a value above 3 indicates the performance quintile in question contains expensive shares on average, and vice versa.
From the chart, it is evident that over 2011, Q5 through to Q3 (top 60% of shares based on performance) contained expensive shares (high CAPE shares or CAPE Q4 and CAPE Q5), while the worst performing 40% of shares (Q1 and Q2) were made up of value shares (low CAPE shares).
The picture changes in 2012. Q5 and Q4 (top 40% of the market in terms of performance) are made up of lower CAPE shares, while the performance of high CAPE shares has shifted down into Q3 and Q2.
The evidence indicates that so far this year, performance has been more evenly spread across the market as opposed to coming just from the expensive (or growth) shares. This may be a lead indicator of a shift from growth to value.
It is gratifying to note, that the rising performance in our portfolios – Cannon equity portfolios have delivered nearly 5% alpha over the past six months – is occurring before a full style shift has occurred, which augers well for our future performance when value does assert itself.
It seems to us that the days of growth outperforming value are numbered. Given this, we believe that investors should examine their portfolios to ensure that they are, indeed, invested in value stocks. Happily, there is still time to switch to value, but not an extensive amount.
