Contrarian value investing, defined in its original form as buying unpopular assets that are substantially undervalued relative to an estimate of fair value, is facing the threat of extinction. Last year marked a decade of underperformance - and produced three of the ten worst monthly returns since 1995 - which we believe has been driven by five major forces.
The Five Foes of Value
First, huge flows into passive investment vehicles have directed capital into the biggest global companies, with investors essentially following a momentum-type trading strategy that makes highly valued stocks even more expensive. The USD 5 trillion rotation from active management has reduced market efficiency by removing the price discovery mechanism and investors' responsibility to engage with companies, but also creates huge opportunities with some stocks at depressed valuations not seen since the aftermath of the financial crisis.
Second, the rise of "Super Big-Tech" companies has created winners and losers, enabling the victors to surmount traditional barriers to entry and disrupt global industries. Frequently the valuations of these mega-cap companies assume unrealistic monopolistic margins, despite their fledgling businesses. Meanwhile, those in sectors such as retail and media have collapsed as many investors now consider them to be uninvestable. We believe this also creates opportunities as the market increasingly sees things in black and white, often failing to value stocks accurately.
Third, the ultra-low interest rate environment has lowered investors' required return to hold long duration assets and fueled the attraction of companies offering unrealistic long-term rewards. With share prices boosted by multiple expansion despite anemic earnings growth, we believe even a small uptick in interest rates could cause a severe contraction - particularly if it coincides with falling earnings growth - and a significant rotation into value assets.
Fourth, investors' aversion to career risk and increasingly short-term focus, combined with a shrinking pool of active value mandates, means that non-passive funds have also herded into momentum-like stocks. This penguin-like behavior can be observed among investment consultants and equity analysts as well as investors, and has resulted in ever-diminishing analysis of underlying asset prices.
Fifth, a growing belief that intangible assets provide the key driver of company growth has seen traditional value metrics such as price/book and price/earnings viewed with increasing skepticism. While intangibles clearly have economic benefit, particularly for software companies or those selling branded consumer goods, we question why the market today thinks that they have suddenly become so much more valuable to the extent that tangible assets are often ignored.
The Ghost of 1972
Today's polarization echoes the 1970s when a "Nifty-Fifty" group of US 'growth' stocks massively outperformed. In a volatile economic environment, characterised by low real interest rates and the Cold War, they were bid up to absurd valuations thanks to an idealistic growth outlook with long-term profits discounted using an excessively low discount rate. When oil prices started to rise in 1973 and inflation pushed interest rates higher, enthusiasm for the Nifty-Fifty collapsed as did their share prices, which underperformed the S&P 500 by around 40% for the remainder of the decade, despite beating earnings expectations.
A new set of "elite" stocks such as Netflix, Paycom and Salesforce have emerged over the last decade, during which investors were prepared to buy similarly utopian "growth" prospects and perceived "low volatility" at any price. The reborn Global Nifty-Fifty trades at eye-watering multiples (13x EV/Sales, 29x Price/Book and 128.3x forward earnings) and their combined market cap of USD 2,302 billion represents over 6% of the total MSCI AC World index. The group is unsurprisingly dominated by US companies, particularly those from the Information Technology and Health Care sectors, with 13 stocks operating in the IT software sub-sector (16x EV/Sales, 126x Price/Earnings and 28x Price/Book).
Welcome to the Underworld - The Global Thrifty-Fifty
In contrast, the "Thrifty-Fifty" cheapest global stocks - which include Porsche, KB Financial and Gazprom - represent unpopular but attractively valued companies trading at an average equal weighted Price/Book multiple of 0.4x and less than 5x earnings power. We observe a complete detachment in performance between the Nifty-Fifty and Thrifty-Fifty since the beginning of 2017 with the Nifty-Fifty outperforming by in excess of 120%. Over the last decade the accumulated difference between the two baskets is over 450%.
The charts below breakdown the two groups by geography and sector. The US represents around a third of the Nifty but it is almost non-existent in the Thrifty, where South Korea and Japan feature prominently. The Information Technology and Health Care sectors dominate the Nifty, while Financials make up a significant part of the Thrifty, representing over a third of the world's cheapest stocks.
Five Emerging Catalysts for Change
Fashions come and go in financial markets but the current investor herding represents one of the most extreme environments in recent decades. While nobody knows how long it will last, we believe there are five key factors which might backstop and violently reverse the massive underperformance of value stocks in the mid to long-term.
First, the maturation of "Super-Big Tech" and its disruptive global impact. It is virtually impossible for these companies to maintain current growth rates and there will be increasing regulatory pressure to break up these entities given their domination and the growing societal risks they pose. At some point they will become vulnerable to cyclical forces as growth rates fade while investors also underestimate the ability of structurally challenged 'dinosaurs', particularly in the food retail and media sectors, to adapt and generate decent shareholder returns.
Second, valuations at lows not seen since the financial crisis will drive consolidation. Some market segments are currently exceptionally cheap (e.g. European banks, pulp and lumber stocks, auto and auto-part makers as well as Japanese small and mid-caps and Korean equities generally) and look ripe for private equity and strategic buyers to demonstrate the "true" value of their assets.
Third, the market is gradually starting to sense a new wave of stimulus on the horizon via synchronized monetary easing to meet the perceived threat of a global recession, supplemented by fiscal measures. We anticipate that even small changes in the interest rate environment will negatively alter the valuation dynamics of the more expensive areas of the stock market and drive capital flows to higher cash yielding value equities.
Fourth, a resolution to the global trade war. The US-led tensions have diverted further capital into safe havens without assessment of the price paid for underlying assets. The recent clarification or "mini-deal" is an interesting starting point in this process and further reduced trade tension would likely be highly beneficial for value stocks.
Fifth, as larger-cap companies experience falling growth rates and underperform expectations, capital should flow towards smaller and less popular value stocks. Trend followers and quantitative robot-like momentum investment models will gradually turn their attention to the previously ignored areas of the global equity market and further support this capital reallocation.
Valuation will matter again
In conclusion, global equity investors today are faced with an extremely polarized market. If we are anywhere near right, the potential exists for a massive rotation from excessively valued "low-volatility growth stocks" into attractively priced value stocks with strong cash flows and tangible assets. At some point valuation will matter again.
An intriguing cocktail of maturing growth rates in globally disruptive companies, adjustments in capital flows, thawing trade tensions, monetary and fiscal stimulus, and increased M&A activity could propel the rotation. At the very least, it would point to a more balanced investment approach between what has worked over the last decade versus what has been successful over the last century.
Jonas Edholm is portfolio manager, SKAGEN Focus
