27four Investment Managers
7th October 2015
Don’t give up on value investing
The wheel always turns.
CAPE TOWN – The last four years have seen one of the longest periods of value investing under-performing growth in the South African market. And over the last year, this discrepancy has become even more pronounced.
As the below graph shows, the FTSE/JSE Value Index out-performed strongly from 2008 to about mid-way into 2011. Since then, however, the FTSE/JSE Growth Index has turned the tables.
The biggest disconnect, however, began from around the end of 2013. Over the last few months in particular the value index has dipped significantly, while growth has effectively held steady.
Investment growth, growth vs value
Markets driven by sentiment
The first thing for investors to understand is why this has happened. It is not a local phenomenon, as similar tends have played out all over the world. This is largely a consequence of the global financial crisis which put the brakes on global economic growth and had a huge impact on market sentiment.
“Value lags in periods where economic growth and corporate profit growth is hard to come by,” explains Ricco Friedrich, portfolio manager at Denker Capital and co-manager of the SIM Value Fund. “That is what we have seen since the global financial crisis. When there is a scarcity of growth, growth becomes overpriced.”
In this environment, growth investing becomes a self-fulfilling prophecy. Investors have gravitated towards more defensive companies that have been able to sustain earnings growth and positive cash flows.
This has pushed their share prices higher, making them even more appealing to other investors who share the same views. On the JSE, this trend has been most noticeable among consumer goods companies, retailers and healthcare stocks.
At the other end of the market, cyclical companies like those in construction and mining, have struggled to generate earnings growth because of the low demand for their products. Consequently, they have been shunned by investors.
“In this environment expensive stocks have become more expensive and cheap stocks have stayed cheap,” says Friedrich. “And that does not favour value investors.”
This disconnect has become steadily more pronounced and is now at highly unusual levels.
“The cycle has kept feeding into itself,” says Nadir Thokan, investment strategist at 27Four Investment Managers. “And now we are sitting at valuation extremes where cheap is very cheap and expensive is very expensive.”
The right time for value investors
In theory, Thokan says, this is the sweet spot for value investing – where you get a free option on value because you can be certain that there must be some sort of mean reversion.
“Either the expensive part of the market needs to de-rate, or the cheap end needs to re-rate,” he says. “And that’s when the value manager should benefit the most.”
If one takes sentiment out of the equation then, it would seem that the longer the current cycle continues, the closer it gets to its end. It is also likely that the longer the shift takes to occur, the more significant it will be.
For a multi-manager like 27Four, this is an important consideration, because it has to allocate capital to different managers and different styles. Thokan acknowledges that they have started to move some assets towards value managers, but that this is not a simple decision, particularly in the local market.
“The problem we have with allocating to value, particularly in South Africa, is that value managers have missed the boat a little bit,” he says. “In theory they should be buying companies that are undervalued because they are going through a temporary earnings blip and once the cyclical normalises those profits and the value of the business will go up again. So they would be buying at an intrinsic discount to fair value.”
However, a number of value managers in South Africa appear to just be buying the shares that look the cheapest, and largely that has been resource stocks. The problem is that while these stocks may be trading on exceptionally low price-to-book multiples, one can have very little confidence in their earnings potential.
“These are poor quality businesses,” Thokan says. “Their earnings prospects are not great because they are very correlated to commodity prices and commodity prices are on a slide. The fall we’ve seen over the last year isn’t even reflected in their earnings yet, so you have to think we’ll see even further downgrades.”
Investing in value from here is therefore not a simple one-way bet. Much of the cheap part of the market is cheap for a reason, and it has to be treated selectively.
“The valuation extremes in the market do offer an opportunity,” Thokan says, “but we are not as optimistic on value as we would be simply because the value end of the market does contain a lot of poor quality companies that are highly cyclical.”
Therefore just as one can’t be indiscriminate about buying stocks that look cheap, one also can’t be indiscriminate about choosing which value managers are most likely to outperform.
What an investor should want to see from a value manager in this environment is a clear idea of risk management. That means that when it comes to allocating capital, the manager should not just focus on the upside potential in stocks trading at very low valuations, but also how much capital they are potentially putting at risk to achieve that upside potential.
For those that get that right, the opportunity may well be there to take advantage of.
Author: Patrick Cairns