Value is subjective.
Whether it’s property, art or professional advice, people assess value differently.
People consider and prioritise different factors, depending on their individual needs and preferences.
With property, for example, some people value and will pay more for attributes like off-street parking, aspect and local schools.
Yet, in asset management, a company’s fair value is often assessed on fewer and simpler dimensions.
Managers typically focus on indicators like a stock’s price-to-earnings ratio (PE ratio) to determine if it is trading above or below intrinsic value. Value investors look for companies that they think the market is underestimating.
Based on this metric alone, a company with a PE ratio of 15 is greater value than a company with a PE ratio of 30 because investors are effectively paying half as much for each dollar of the company’s earnings.
While it sounds logical in theory, many investment strategies based on buying the cheapest stocks and short selling the most expensive have underperformed.
In Australia, simplistic value investing has failed to consistently generate alpha. Globally, performance has been weak for over a decade.
There are a number of reasons for this.
Firstly, value investing has become a very popular investment approach. This is partly due to the availability of vast amounts of data and information via the internet including social media platforms like Instagram and Tik Tok.
The use of simple, quantitative metrics by finfluencers and retail investors has become prolific.
Widely published information, including analysts’ earnings estimates, is quickly priced into the market.
Secondly, most people use simple metrics to judge value.
Like most things in life, just because a stock appears cheap doesn’t mean it’s a good deal. Similarly, a stock that appears expensive may not be worth the price tag. Only further research can uncover hidden insights that others may have overlooked.
Proprietary insights
To exploit the best opportunities and deliver alpha, managers can’t rely on readily available information.
With company announcements and financial accounts, alongside well-known structural, regulatory and macro-economic factors, efficiently priced in, investors need to gain an information advantage.
Future earnings are a strong value signal but the ability to accurately and consistently predict future fundamentals is extremely difficult.
In lieu of a crystal ball, managers must continuously enhance their investment processes to generate unique ideas and proprietary insights in order to competently estimate actual future earnings.
Technology is playing an increasingly important role.
There is a lot of talk about Artificial Intelligence (AI) and how it is changing the way people work. In asset management, there is a huge variation between how AI is being used by firms. Many are still in the infant stages, using AI to perform basic functions like algorithmic trading and rudimentary content creation.
Others are significantly more advanced and have embedded AI into their investment process to help them hunt for long and short ideas at an industrial scale.
AI can comb through volumes of information at record speed, cross reference data for anomalies, and add important nuance to analysis.
For example, humans struggle to find patterns in anything with more than three dimensions. But AI can analyse the interaction of data from myriad sources to make earnings forecasts that factor in information like analyst biases, past surprises, and supply chain and competitor data.
It is often difficult for humans to spot a good deal, not only due to a lack of quality information but also because of inherent cognitive biases and emotion. Computers and AI, on the other hand, are less susceptible to preconceived ideas and prejudices.
Heartbeat detected
For a long time, investors, particularly conservative investors, bought the value story and, in turn, the value label.
Around the turn of the century, in an era of higher interest rates and before the digital information age, value investors enjoyed success.
Since then, the style has struggled, although some managers have performed better than others.
The top quartile of global value funds outperformed their preferred benchmark by around 2.4% per annum in the 10 years to December 31, 2023, however, the bottom quartile underperformed by circa 2 per cent per annum.
The disparity between the top performing value managers and the worst performing value managers highlights the importance of distinguishing luck from skill.
There are many different ways to construct and manage portfolios, and every value manager has their own investment philosophy, process, systems and technology.
That’s true of managers across the board, irrespective of style. However, for strategies focused on other styles like growth and quality, there’s less universal agreement on how these metrics are defined and, therefore, greater scope to demonstrate skill and outperform.
Growth, by definition, is also more forward looking.
While a decade of headlines about the underperformance of value investing may suggest a bleak future, it remains a sound investment philosophy, if approached with care and sophistication.
Generic value investing may be on life support but there will always be a place for investment managers that can identify and exploit an informational edge when attractive buying (and selling) opportunities, derived from unique signals and proprietary insights.
Zhe Chen, senior vice president, portfolio manager, research, Acadian Asset Management.
