Good investing is not fashionable

US President John F. Kennedy once quipped that “success is a child with many fathers; failure is a lonely orphan”.

Being a disciplined ‘value’ investor must have seemed a lonely struggle during the years of the dot-com mania.

The euphoria surrounding new economy companies tested the mettle of investors focused on buying oversold stocks.

Now, well-executed value investing has again been proven in investors’ eyes, with more than five consecutive years of very strong performance, both relative to the market index and in absolute terms.

Cautious investors may question how much longer this performance trend can continue.

A drill down into a successful global value strategy reveals that there are still very good opportunities for this approach. Many of the opportunities require thinking differently.

The same research also highlights the emergence of strong opportunities for ‘growth’ investors. The good news is that these opportunity sets are not mutually exclusive.

A closer look at a successful global value strategy

Near the height of the dot-com euphoria AXA had begun work to create a new global equities ‘value’ fund for the Australian market.

Now approaching its fifth anniversary, the AXA Global Equity Value fund has become established as a recognised fund for retail investors, consistently producing top quartile performance, receiving very strong independent fund ratings and several ‘manager of the year’ awards.

The fund is a product of a unique relationship. A joint venture established in Australia between AXA and AllianceBernstein provided the opportunity to bring one of the world’s best-regarded ‘value’ managers to the local markets.

The Bernstein Global Value approach has been successfully implemented for almost 40 years.

While that strategy has been successful, it is reasonable to question the likelihood that ‘value’ strategies will continue to perform well after such a strong period of outperformance.

The answer lies in understanding what drives the return outcomes for these strategies, and what potential exists in the current market conditions.

Searching for value

Bernstein is a non-follower-of-fashion. In fact, key elements of the process are built around a deep understanding of investor behaviours and understanding when to be different from the crowd. These behaviours have the potential to destroy wealth. But they can also provide opportunities for investors who understand them.

We all hate losing money — even more than we like making it. Behavioural biases to loss aversion systematically result in anxious sellers looking to exit certain stocks at very depressed prices.

Value managers can harvest these opportunities if they have the processes and research to distinguish between permanently depressed prices and those that are transitory. Simply being contrarian is not good enough.

On occasion, the market may fail to recognise underlying value for some time, leaving the ‘value’ approach underperforming market indices during such periods.

Evidence of a manager’s skill can’t be fully assessed partway through such periods. Rather, the proof of the pudding is the performance of the portfolio when the buyers return to fundamental value.

From the second half of 1997 through to the middle of 2000, Bernstein’s Global Value approach underperformed the MSCI World Index. Ultimately, however, their research-based investment conviction was strongly rewarded as the Internet bubble burst, enabling all of the lost ground to be recovered within one year.

Moreover, over the next three years, their returns moved ahead of the market return by nearly 40 per cent on a cumulative basis.

A deep fundamental research commitment has always defined Bernstein’s against-the-grain investment approach, but perhaps never more starkly than during that period. It was a testing time for a manager’s conviction, and not all fund managers stayed the course. Frequently, Bernstein’s research analysts examined the assumptions that led them to adopting a controversial position by avoiding the popular names of that era.

But each time they came back to their original view that most technology companies would never generate the earnings justified by their inflated share prices.

Tight valuation spreads now — but still opportunities

Now, six years after the bursting of the Internet bubble, investors may be worrying that the value style’s winning run may be losing momentum.

An examination of stock valuations reveals that the spread between the most expensive and least expensive stocks is narrower than it has been for some time. At the cheap end of the scale the discount to fair value is slightly lower than the historic average.

Using price earnings ratio (PE) as a proxy for valuations, the chart on page 26 (Chart 1) (please see Money Management Magazine November 23, 2006) shows the ranges of valuations currently prevailing compared with long-term averages and the extremes of the 2000 dot-com period.

Overall, the global market PE is around the long-term average, and substantially below the expensive levels prevailing in 2000. The chart also shows the cheapest 20 per cent and most expensive 20 per cent of the stocks in the market when ranked by PE.

The discount of the cheapest stocks compared with the market average is now lower than the historic average, although it is still meaningful. Note that the difference between a PE of 11x compared with 16x implies a discount of more than 30 per cent is still available for the cheapest group of stocks (see Chart 1). (Please see Money Management Magazine November 23, 2006 page 26)

Research into the causes of today’s narrow spreads and comparisons between today’s situation and previous similar periods may provide an insight into what may happen next.

Two factors seem to be at play.

~ First, investors are far less confident today about long-term company earnings than they are about immediate earnings, so they’re unwilling to pay up for future earnings. This is understandable: earnings growth has been so impressive in recent years that investors are cautious about expecting more. So growth stocks are not selling at their typical premiums.

~ Second, there is an absence of the economic stresses that can push entire industries or sectors into distress and, thus, there are few really cheap stocks.

We have seen these conditions before. Both these factors were present in previous instances of small valuation spreads. In all cases, once they hit an extreme, the differences in stock valuations increased again, roughly within the following two years.

While there is some potential for truly distressed stocks to get cheaper, the biggest deviation from the average is among the group of higher PE stocks. Among this group, a current PE 37x compared with a long-term average of 50x implies good re-rating potential for those stocks, that can sustain earnings growth.

Value managers are now using a broad set of opportunities and tools.

What should the manager’s response to a lower opportunity set for value be?

One view is to concentrate on a smaller group of stocks and increase the size of the positions. This idea is underpinned by a notion that risk is smaller than the opportunity, hence assuming greater risk is a sensible course.

Interestingly, the Bernstein Value team has a contrarian view on this approach also, considering that only a marked pick-up in stock mispricings would justify increasing portfolio risk meaningfully. And that time still seems a little while away.

As a better alternative, AXA and AllianceBernstein have worked to ensure the widest practical mandate for the manager, capitalising on the extensive global research capability to look for value well beyond simply the stocks represented by the index. Rather than being restricted to around the 1,800 stocks comprising the MSCI World Index, the manager’s investible universe is more than 3,000 stocks.

In addition to a broader opportunity set, managers may also seek to use a diverse set of decision tools. With a broader set of tools the value investor can keep on winning, even if perhaps by more modest margins than the past five or so years.

Bernstein’s intensive company and industry research is still enabling them to uncover instances where price/earnings, price/book-value and price/sales ratios are below average.

And they’re also going beyond classic value measures in this environment, paying special attention to factors like stock-price momentum and return on equity. Bernstein’s research has found that when coupled with attractive valuations, these additional measures can further pinpoint stocks with outperformance potential.

The search for value finds it in unexpected places. Conventional wisdom is that the largest stocks are the most accurately priced by the market, and managers, therefore, are more likely to find mispriced stocks among medium to small companies. Bernstein’s research indicates that the opposite conditions currently prevail.

Chart 2 (please see Money Management Magazine November 23, 2006 page 26) shows that while the return on equity for both very large and mid-cap stocks is near the long-term average, valuations are very different.

Very large cap stocks have traded on an historic premium to the broader market of nearly 5 per cent. They are currently trading on a significant discount of nearly 10 per cent. Conversely, mid-cap stocks have historically traded at a discount to market, but are currently trading at a premium of nearly 10 per cent.

The upshot is that history provides several useful lessons for today. It tells us that value investing can succeed even when valuation spreads are below average, even if not on the magnitude possible in more unsettled markets.

Furthermore, that success can be magnified by capitalising on clues other than classic value measures, which when combined with low prices can tilt a value manager’s winning odds in a favourable direction.

What does it mean for investors?

Value strategies work very well for equity investors with the right investment horizon and discipline. Using intensive research to identify stocks that others are selling for emotional reasons is a proven strategy, and it has delivered outstanding results over recent years.

It seems likely that the unusually strong results of recent years will be more moderate in future years, but the strategic role of a ‘value’ approach to equity investing remains valid, with good managers still finding genuine opportunities.

While changes in valuations do not diminish the role of value investing, they do open the potential for ‘growth’ investing to also return to a period of above market performance.

Mark Dutton is the chief investment officer for AXA Australia.