Market shake-up forces rethink in hunt for value

It’s been a tough 18 months for value managers who have watched many of their long held beliefs being tested by a changing market. Zilla Efrat examines how Rothschild has risen to the challenge.

Growth stocks have significantly outperformed value stocks over the past two years, leaving many a respected value manager languishing at the bottom of the performance tables.

But, according to Rothschild director of Australian equities Andrew Brown, value managers are no dinosaurs.

He does concede, however, that a number, including his own company, have had to review their investment styles and re-invent themselves over a very short time.

The catalyst, he says, has not been a cyclical market force like the ongoing bull run, but, rather, structural changes in the Australian stock market.

Among the developments testing the traditional approach of value managers are an increased presence of what he calls "long duration" businesses in the All Ordinaries Index, a proliferation of interest rate sensitive companies and newcomers who have no history with which they can be compared. Added to this is a narrower market that favours index traders.

"We realised that unless we made some changes, we would get stuck behind the eight ball," says Brown.

"Value managers using 1980s techniques may struggle," he adds, noting that the changing market has forced some to focus less on the past and more on cash and capital management.

The "black box" methodology typically used by value managers - where the focus is on quantitative factors and screening data rather than a company's fundamentals - is also under pressure.

Value managers now have to use longer term tools and make better use of the technology and information sets available to them. In addition, they have to think more globally, but act locally.

Unlike growth managers who focus on future earnings prospects, value managers look at price and how this differs to some kind of mean - like the average Price Earnings ratio of a sector or the usual premium at which a stock trades to its rivals.

Value managers believe the market is basically inefficient and they are constantly on the hunt to find a gap, and take it, before the price reverts back to the mean.

To do this, they have to look backwards at what has happened before.

But, according to Brown, this approach has been shaken up by market shifts caused by such things as the privatisations and demutualisations of recent years.

As a sign of just how much the market has changed, he says more than 17 per cent of all the shares that make up the All Ordinaries Index were not listed three years ago. And, one third of those comprising the 20 Leaders Index were not listed ten years ago.

Because of this, value managers have no history to fall back on and cannot look at what happened to, say, AMP just prior to the 1987 crash.

In addition, some of newcomers, like Telstra, have no local rivals with which they can be compared - highlighting an ever growing need for wider and more global peer group comparisons.

Added to this, is a change in the composition of the All Ordinaries Index.

According to Brown, the financial sector now makes up 36 per cent of the index, compared to 16 per cent in 1988. Likewise, the weighting of the services sector - which includes media, telco and retail stocks - has jumped from 15 per cent to 36 per cent.

He adds that the index is now more populated by what he calls "long duration businesses" - or those with long term, annuity-type income streams, flowing from repeatable, low competition business.

These now make up about a quarter of the All Ordinaries Index, compared to an estimated 5 per cent four years ago.

Long duration businesses are normally growing companies with high sunken costs. And, it usually takes a longer time before an investors gets their money back from them.

An example would be Transurban, which has invested heavily in a road which will generate an income stream every day for 99 years.

In the wake of the thrust towards privatisation and demutualisation, listings of "long duration businesses" like life companies and telcoms have flourished on the Australian Stock Exchange (ASX).

Other newcomers to the market have also included gaming groups (eg Tabcorp) and "annuity-type" companies like Computershare.

These stocks, the rising stars of recent times, pose new problems for value managers. While growth investors are typically willing to pay high PE ratios for shares that have a longer pay back time, value managers are not.

The changes have meant that instead of focussing on figures like relative PE ratios, value managers like Rothschild have turned to a calculation not previously found in their tools boxes - the analysis of discounted cash flows.

This is particularly so because of the growing dominance of interest sensitive stocks. Indeed, according to Brown, 53.5 per cent of the All Ordinaries Index is made up of interest sensitive stocks - compared to an estimated 20 per cent about ten years ago.

Included among these are the long duration stocks (25.1 per cent of the All Ordinaries), banks (23 per cent) and listed property trusts (5.4 per cent).

"The ASX has moved from being one of the least interest sensitive markets to being one of the most," Brown says, noting that out of the eight stocks which make up 40 per cent of the index, four are banks.

Added to this trend has been a significant fall in real interest rates as investors no longer consider inflation a major threat. Nonetheless, the risks of any interest rate hikes - and the possible effects company performance - have also helped bring discounted cash flows analysis to the forefront.

Brown says value investors tend to favour basic industries like building materials or other manufacturers because they trade at lower multiples to the rest of the market.

"These are capital consumptive companies. They need to keep investing in their businesses if they want to grow and maintain their global competitiveness."

As a result, they can be "cash burners" rather than "cash generators", offering

lower returns and higher risks if they become cash flow negative.

Last year, value managers lined up to grab building material companies shares because their PE ratios looked cheap. Building materials, however, was the ASX's dog sector in 1998, falling by about 33 per cent.

Another change is a narrower market where just a few stocks make up the bulk of the All Ordinaries Index, a trend which favours index replicators.

Last year, for example, growth managers stampeded into the same few stocks - Telstra, Brambles and Coles Myer - for safety after the Brazilian and Russian crises and they didn't care what they pay for them, pushing their PE ratios sky high.

Brown says value investors hate a narrow markets and would never follow this approach because they look for opportunity in stocks that other investors are afraid to touch.

"The pace of structural market change may be reducing, but it is not stopping," Brown says, pointing to the likelihood that more utilities will eventually list on the ASX.

But he adds: "We may have made some changes to our process, but not our style. We are still very much value managers."