It can be counterintuitive, but one of the surest signs that investors are starting to feel that the market is getting expensive is when the pundits start declaring that value is dead. This has been the case during just about every speculative bubble dating all the way back to the South Sea Company in the 1700s. This tendency to abandon logic – as investors seek comfort in the idea that the old rules don’t apply – will always end with a renewed appreciation for stocks’ intrinsic value.
In more recent memory, traditional metrics like P/E ratios were deemed irrelevant amid the dotcom hype in the late Nineties; they weren’t. At various points over the past ten years the conventional wisdom has been that an accommodative monetary policy, coupled with the growth of passive investing, has finally killed off value investing; make no mistake, it has not.
This past June, the Financial Times went so far as to characterise value strategies as “an article of faith” among adherents of Benjamin Graham. What this overlooks are the natural laws of the markets in which investments in high-quality companies with low P/E ratios and low price-to-free cash flow ratios consistently work for long-term investors unmoved by periods of market irrationality. This is not to say that over the short and medium term there won’t be stretches when other strategies perform better, but the later stages of an extended global recovery is hardly the time to abandon the tenets that have previously worked.
To be sure, the accommodative monetary policy since the financial crisis has distorted both the equity and fixed income markets, giving rise to “lower for longer” views that have applied to everything from interest rate policy and oil prices to volatility and even returns. Against this backdrop, investors have moved roughly $2trn into passive equity funds and ETFs over the past decade, according to Bernstein Research, and withdrawn $1.5trn from active strategies. This is being led by the belief that active management cannot outperform the benchmark.
Quite obviously these developments have had an impact on the broader investment landscape. In many respects, index funds and ETFs have helped to extend the market cycle through facilitating thematic approaches in which crowds can easily move into and out of certain trades, such as technology. This generally occurs without any consideration around the fundamentals of the companies that comprise the index. But to imply that value is no longer relevant is a pretty sensational leap that has already cost investors in certain circumstances.
A clear example of this has been crowding into certain “bond proxy” stocks. In the U.S., where the Fed has started normalising its interest rate policy, the impact has been predictable. The S&P 500 telecom services stocks, which were a favourite of the low-volatility and high dividend-yield ETFs in 2015 and 2016 which have seen their fortunes reverse as relative performance in these names has weakened considerably. The Reits segment is another example of a group beginning to crack after strong investor interest in the low-yield environment.
Across the world, certain pockets continue to be overvalued. The MSCI World Consumer Staples index is trading at a price-to-earnings ratio that exceeds 24x and a price-to-book of above 4x, as of June 30. Valuations at these levels are typically reserved for high-growth technology stocks, not chocolate bars and laundry detergent.
The bubble forming in utilities is even scarier. Just looking at the top utilities in the S&P 500, eight out of the top ten have produced negative free cash flow over the prior 12 months. Yet, the stocks continue to move higher as the sole attraction in these areas has tended to be dividends – largely funded by debt, asset sales or new share issuance. Does an ETF manager care if a company cannot fund its dividend with internally generated cash flows? Any investor with an appreciation for value would argue that they should.
So the question for long-term investors is what would you rather own: a utility such as Southern Company trading at nearly 18x earnings as of late July, yet doesn’t generate enough free cash flow to pay its dividend, or a bellwether financial institution like JPMorgan Chase, valued at 14x earnings, but supported by consistent top- and bottom-line growth and earnings over the past four quarters that easily beat expectations? Add the catalyst of a rising-rate environment in the US and the answer should be obvious.
To be sure, amid these elongated cycles it can be difficult to stay true to the principles that have forever guided those of us that call ourselves value investors. The risk, however, in changing course is that investors will lose the margin of safety that is inherent when you’re focusing on the intrinsic value of companies. This is also a core element that supports long-term outperformance.
Value will return – it always has. In the long run we know that fundamentally good businesses that use capital wisely will outperform those that don’t. Value is not dead, but it is testing the faithful. Despite all the proclamations and noise, we are sticking to our longstanding value approach, which has served us well over time.
Mark Donovan is co-CEO and portfolio manager at Boston Partners