Have investors capitulated against Value?

Geoff Blount, CEO of Cannon Asset Managers, shows that the market has all but abandoned value stocks over the last few years with most investment managers shifting their portfolios to more expensive growth stocks. This will have significant implications f

In considering the drivers of investment returns in recent times, it surprises many investors to discover that, from a style perspective, the South African equity market has been in a strong growth cycle for the last five years. In many respects it doesn’t seem like this because “growth” is normally associated with euphoric markets. However, in the recent past, demandingly-priced growth stocks have performed well – becoming even more expensive – while the market has ignored or sold down attractively-priced value stocks. This phenomenon also played out in the recent market volatility.

In previous research, we have demonstrated this by examining the Cyclical Adjusted Price Earnings Ratio (CAPE) as a measure of value. But what about using the traditional trailing one-year Price Earnings Ratio (PE) to measure value, and how have low PE stocks done over recent years?

To examine this, we divided counters in the market into PE quintiles at the start of each year, where quintile one is the basket of lowest PE stocks (value stocks), and quintile five is the basket of highest PE stocks (growth stocks) and then track each basket’s performance relative to the market

From research based on data from 1975 to date, we know that, globally, over five-year rolling periods, quintile one stocks enjoy an average 9.8% p.a. performance premium over the market, and quintile five stocks typically underperform the market by 4.7% p.a. In other words, there is a significant investment premium that value stocks deliver whilst, historically, growth stocks, by nature, disappoint investors.

However, since 2005 the exact opposite has taken place in South Africa, where quintile one has underperformed the market each year (as shown in Figure 1). This implies that investors in the South African market have consistently shunned low PE shares over the past six years.

When we conduct this analysis using price-to-book ratios or dividend yields (other common metrics for value stocks), it tells a similar story, contrary to longer term experience. As evidence of this, on average, quintile one high-dividend yield stocks have underperformed the market by 3.2% per annum since 2005, whilst quintile one low price to book stocks have underperformed the market by a substantial 11.0% per annum, over the same period. History has shown that quintile one price-to-book stocks normally enjoy a 7% p.a. premium over quintile five high price-to-book stocks over five year rolling periods.

The implications for investors in South Africa

This recent market behaviour is nothing short of staggering and has some significant implications for investors. Firstly, it is not sustainable, and therefore deep value shares currently present incredible opportunities for investors who are willing to shop in unpopular areas of the market. Secondly, we believe that most investors, including many that define themselves as value investors, have given up on value shares and migrated or drifted to growth, or more expensive shares which is where the momentum has been. This is evident in research undertaken earlier this year by independent research house Morningstar in their Style Box™ style plot analysis of equity unit trust funds in South Africa. The results are summarised in Table 1¹.

To be overweight a style, a portfolio must have more than a 33% weighting to it. The average general equity unit trust is strongly underweight value stocks, at weight to core (shares that are neither value nor growth) and dramatically overweight growth stocks. Astoundingly, the value category analysis shows the average value fund is underweight value and amazingly, is overweight growth. This is clear evidence of style drift. By contrast, the Cannon Equity Fund is rated by Morningstar as the purest value fund available with the highest value attributes and the lowest growth attributes. This analysis also showed that amazingly among all the asset managers in South Africa, there are only two equity unit trusts that are overweight value.

Table 1: Morningstar Style Scores for various Equity Unit Trust sectors

As the performance of investment styles is cyclical, the temptation to “style time” the market is very high. At Cannon, we believe that it is incredibly difficult to successfully rotate the investment style of a portfolio. Evidence indicates that style rotation actually subtracts value, as the rotation is normally done after the fact and often too late. Another risk for investors is style drift where the portfolio slowly migrates it characteristics over time. The danger here is that the investor believes they have bought certain attributes in a manager’s portfolio, only to find that the portfolio no longer owns them, normally only after those attributes start rewarding investors and it is too late.

Table 2: Current Attributes of our Houseview Equity Portfolio

As you can see from Table 2, our portfolios continue to enjoy strong valuation discounts to the market as shown in the first three metrics. But it is not just about buying shares on low ratings. As a proxy for quality, the Return On Equity (ROE) of our holdings is higher than that of the market, indicating that the shares we own are more profitable than the average in the market. And finally, as a proxy for expected returns, we use broker consensus Earnings Per Share growth forecasts. Not only do the shares we own enjoy a discount to the market, offer greater quality but they also look set to grow earnings ahead of that of the market. We believe that these attributes in our portfolio are a powerful combination that do and will handsomely reward patient investors over time.

In analysing asset manager performance, investors need to assess the extent to which a manager’s performance deviates from their stated objectives and approach to investing. In other words, does the manager’s shape of performance match what they set out to achieve or what you expect them to achieve? If a value manager performs well in growth style markets, it indicates a problem. If the manager is doing exactly what he intended to do, then the investor is getting the type of portfolio that he has chosen and the performance that has been achieved is a result of manager skill and quality rather than luck.

Luck can work in both directions: by selecting a manager based on his investment skill, an investor is less likely to be exposed to nasty surprises.

This is of particular importance if an investor is blending different styles, investment approaches and philosophies. When investing with a particular manager, you want to know that you will get the type of fund performance and attributes that you have chosen. Investors first need to seek an asset management company that is consistently applying its investment philosophy and process and then to look for one that shows superior performance traits. Through this discipline, luck is removed from the investment process and true investment skill is embedded.