Is investment style relevant in South Africa?

An increasing and common refrain we hear from consultants and wealth managers is that the South African market is too small for investment style to be relevant and, therefore, it does not matter. This sentiment is typical at the end of an extended growth style run and the investment industry is, once again, displaying collective amnesia. Towards the end of the 1990s, there were only two value managers left in SA, and plenty of growth managers, with the general observation that "style doesn’t matter”.

 

History seems to be repeating itself as we experience an extended growth cycle. We believe there are now only three value managers left in South Africa and the general observation being made is that style is irrelevant in our market.

 

Investment style is often dismissed in SA because our market is "too small”. However, at Cannon we believe that in any market where price differentiation occurs, style exists. Take the extreme market of two stocks only, one on a PE of 20x and the other on a PE of 10x. The market will have an average PE of 15x, but one stock is priced with high future expectations and the other low. There is value and growth in this market.

 

Another argument trotted out against style in South Africa is that there are insufficient value opportunities on the JSE. This is more a comment on the size of the manager making the statement and their limited investable universe, rather than the value opportunity set. Simply put, most managers are too large to be value managers in SA.

 

If Value and Growth exist in South Africa, can this be measured? The answer is "Yes”. In Chart 1, we have plotted MSCI style indices and the market for South Africa.

Source: Cannon Asset Managers, MSCI South Africa, Value and Growth Indices (2014)

What is very clear from this chart is that, over time, Value outperforms Growth, as well as the market. However, this outperformance does not occur in a straight line but is cyclical. In Chart 2, we show the same data as Chart 1, but plot the MSCI Value Index over the MSCI Growth Index. When the green line is rising, it means that value is outperforming growth, and vice versa. We also show the average starting and ending PE for periods when value and growth outperform.

 

This chart is fascinating on a number of levels:

 

• It indicates the immense cyclicality of value and growth as styles.

• It shows that we are in the longest growth phase the SA market has on record, and while not the deepest, the cumulative effect of its length and depth make it the most powerful growth market SA has seen since the style indices were created.

• It indicates that the market PE (as shown at every peak and trough of the cycle) typically:

o expands when growth outperforms (the market gets more expensive relative to earnings).

o contracts when value outperforms (the market as a whole gets cheaper).

• The cyclicality of style begs the question, why not "style time”? The reality is that it is incredibly hard to get right and no manager has ever shown the ability to do so successfully.

 

Given the current cycle, it is no wonder most value managers have either:

o Gone out of business;

o Capitulated and style drifted; or

o Say value on the label but don’t put it in the portfolio.

 

True-to-style value managers could, simply, not have outperformed in the recent past. Conversely, the current managers that have recently performed well could not have delivered the performance they did without significant exposure to growth shares.

 

Whenever growth reaches its zenith, investors find a myriad of reasons why "this time it is different” and the old rules of investing no longer apply.

 

We have recently completed a research project where we applied the original Fama and French analysis on style in the US, to South Africa. They showed that, over the long run, value stocks, and in particular, small value stocks outperform both the market as well as growth stocks. Chart 3 shows this analysis for South Africa, which indicates the average annual real long term returns for large, mid & small value, GARP and growth styles in South Africa from 1990 to 2013.

 

In the chart, the size of the circle indicates the amount of capital (market cap) in each strategy. The square blocks show the behaviour of the market from a style perspective for 2013 and they show that recent performance is anomalous to the long term average.

 

Source: Cannon Asset Managers (2014) proprietary data archive; analysis from Fama and French (1992 & 1993); Index Fund Advisors (2010)

This chart is highly instructive as it not only breaks the market into three styles, but it also shows the influence of size.

 

• The first observation is that growth investing in any size bucket (large, mid- and small-cap shares) underperforms the market over time, yet 48% of the equity market, and hence investor capital, typically sits in this bucket. No wonder so many investors can’t beat the market over time. In reality, growth does not grow. But in periods where it outperforms, as shown for last year in the pink square, it is easy to be seduced by the "great stories” and wonderful prospects of growth stocks.

 

• 30% of investor capital sits in GARP, which does demonstrate a small advantage over the market.

 

• Only 21.6% of investor capital sits in value. By definition, value investing is a minority sport but it does outperform the total market and growth style by 2.8% and 4.4% p.a. respectively.

 

• Small Cap Value outperforms the market by a staggering 8.6% a year!

 

And if you are going to use a blend of active and passive (or beta) as a long term investor, the active tilts should be in favour of Mid- and Small-Cap value shares.

 

Source: Cannon Asset Managers (2014) proprietary data archive; analysis from Fama and French (1992 & 1993); Index Fund Advisors (2010)

There is a clear argument regarding the merits of investing with a value bias. Investors should seek value asset managers which remain true to style and have the ability to invest in small value stocks.