Value pitfalls brought underperformance

Greg Hopkins, PSG Asset Management’s CIO.

Many traditional South African value fund managers have relatively underperformed over the past five years because of value investing pitfalls.

This stems from a local overcrowded value-biased investment segment rendering outperformance difficult, as well as value investors ignoring industries that are in a structural decline with the risk of investing in value traps. Value investors also took large off-benchmark bets, which brought significant business risk.

This is according to PSG Asset Management’s CIO, Greg Hopkins, commenting in the asset manager’s latest Angles & Perspectives for the third quarter of 2014.

He points out that indeed, the value investment style has outperformed in the US in three out of every 5-years (60% of the time) since 1926. “The investment style does however tend to underperform in periods of recession and below-trend growth, which has characterised the world since the great financial crisis.

“Any pick-up in global growth could see resumption in a mean reversion of margins and earnings in companies that investors have long given up on,” Hopkins says.

The South African investing landscape is competitive, but long-term outperformance for the value-biased manager is possible. It is imperative to have the largest possible universe to invest in. By investing in mid-cap opportunities and offshore competition can be significantly reduced.

“It is however also important not to pigeonhole oneself into a specific style box, which further restricts one’s universe, for example being a value or growth manager. Rather look at quality and value factors in the same investment and always tries to stay open minded while investing in all segments of the market.”

A significant source of underperformance for value managers comes from buying ‘value traps’. These are companies that are perceived to be cheap initially, but prove to be otherwise over the long-term. Structural challenges in an industry can result in deteriorating returns on capital.

“Warren Buffett has a great analogy when he refers to value traps as frogs that stay frogs and don’t turn into princes when kissed. It is important to have a quality overlay in one’s investment process – an important antidote to buying value traps,” Hopkins says.

Taking large off-benchmark bets brings risk. Being benchmark conscious – buying shares only because they are in the benchmark – leads smart investors to buy overvalued shares for the fear of short-term underperformance.

This situation is exacerbated by the current potential overvaluation of many of the largest companies in the benchmark (the JSE Indi 25 has only been this expensive in aggregate three times over the past 50 years).

“We believe that to be unconstrained one needs to have the largest possible universe to invest in, a strong focus on quality to avoid value traps, and a ruthless eye on margin of safety to avoid permanent loss of capital.
“If we can do this consistently and with an open mind, owning companies in our funds that others don’t becomes a significant attribute,” Hopkins concludes.