Over the past five years, or so, value has significantly underperformed other styles of investment, such as growth and momentum. As the portfolio manager of a value-style investment fund, which prides itself on remaining “true to label”, this is a fact I am acutely aware of.
The explanations for this underperformance are largely due to the combined impacts of a lower rate of economic growth and continually falling interest rates. Lower growth has resulted in fewer stocks which can reliably deliver earnings growth, while declining interest rates have lowered the discount rate applied to the company earnings. Add to this the greater ability to fund loss-making disruptors in a cheap money environment, and it’s no wonder that value stocks have been struggling to keep up.
The current consensus view is that interest rates will continue to stay ridiculously low and growth will continue to be challenged. While this sounds highly plausible, the future is, of course, unknown. For example, only three months ago, global growth was on the up and who would have expected us to be where we are today thanks to COVID-19?
It’s also worth remembering that history shows us the consensus view has a tendency to be wrong. In fact, history has shown value often delivers strong returns following significant downturns. For example, following both the tech wreck in the early 2000s and the GFC in 2008, value enjoyed a period of significant outperformance versus other styles of investing.
The explanation for this outperformance is that fundamentals and valuation – the key focus areas for value investors – are often forgotten in a bull market. However, when the tide turns, these factors come back clearly into focus, with investors forced to more critically assess what they are prepared to pay for far-off earnings.
But let’s put the macro speculation to the side and look at a few stocks, their fundamentals, their valuations, and therefore their likely upsides.
The silver lining of any market sell-off is that it provides investors with the opportunity to buy stocks at very attractive prices. Sell-offs, such as we saw in March, often lead to indiscriminate and panicked selling, which sees even high-quality stocks sold off aggressively. This gives value investors, with a slightly longer time horizon, the opportunity to buy premium stocks on value multiples.
Examples of opportunities thrown up by the recent sell-off include Aristocrat Leisure and James Hardie. Both these companies are leaders in their respective markets and will emerge from the downturn in even stronger market positions. Both are expected to deliver double-digit compound earnings growth over the medium-term, meaning that not only are they trading on low absolute multiples, but they are trading at low multiples given their expected growth profile.
In both cases, a simple rerating to their historical multiples would see gains of around 50 per cent from current levels. Further, this is not based on any heroic assumptions around earnings growth, just them getting back to roughly where they were before the downturn over the next couple of years.
While there are plenty of stocks now sitting in the value bucket, where upside looks very compelling, what about the upside in some of the more popular parts of the market?
As I pointed out earlier, the stars have aligned for growth stocks over the past few years and this begs the question – are things already as good as they are ever going to get for these types of stocks? With valuation dispersion between expensive and cheap stocks already at an extreme level and interest rates approaching zero, what is there to push these stocks further to the upside?
Let’s use CSL as an example. This is a great company, no doubt about that, but it is currently trading on around 37x next year’s earnings (based on FactSet consensus). Will the earnings forecasts on which this is based prove conservative? Possibly, as things are going pretty well for CSL at the moment. Could the company stumble? Possibly, because when things are already going well, something may stop firing.
Here lies the issue with stocks that have benefitted from a significant multiple expansion. CSL’s current multiple represents a premium to the overall market multiple of around 130 per cent, approximately double the long-run premium of 65 per cent. Clearly, the market has an expectation that things are going to continue to go well. As a result, an upgrade will be applauded, but it is unlikely to drive the multiple materially higher.
By contrast, any disappointment may be met with a sharp multiple derating. It is the potential “double whammy” of a downgrading of earnings plus a multiple derating, that begins to skew the risk-return profile to the downside for these very expensive, overbought and overcrowded stocks.
As we stand today, there are plenty of opportunities to find quality stocks that have the ability to deliver very strong returns, but which are trading on very reasonable valuations. In our view, buying these sorts of stocks tip the odds back in value’s favour and is at the core of what we seek to do as a true-to-label value investor.
Stephen Bruce, director, Perennial Value Australian Shares Trust
