Dark days for value investors

published 10 March 2020

Value stocks – those that are cheap and unloved – have a long record of outperforming growth stocks – those that are expensive and popular. It’s very easy to make overly simplistic distinctions between “value” and “growth”, and not every “value” investor has had an awful time, just as not every “growth” investor has shot the lights out. But taking a broad view, betting on value rather than growth in the last five years has cost investors in the region of 6% a year, argued Norbert Keimling in a research piece for StarCapital in October.

That’s a massive gap. So what’s going on? The problem for value stocks today is mean reversion – or the lack of it. Mean reversion refers to the tendency of a given trait or data series to move around a long-run average. If the series rises too far above the average, or falls too far below, it makes sense to bet on a reversal (at some point). Not every series is mean-reverting, but in the financial markets mean reversion is logical.

Company valuations are ultimately based on earnings and profitability. In a society built on free-market capitalism, a company that makes unusually high profits should attract a swarm of entrepreneurs, all competing to offer a better service at a lower cost. This should ensure that outsized profit margins are eroded away. (Similarly, if margins slide due to oversupply, then weaker firms will go out of business, pushing margins higher.) If profit margins revert to the mean, stockmarket valuations should too.

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However, says Keimling, in this cycle “many growth stocks have been able to maintain their above-average growth rates and profitability... much longer than in the past”. Why? Firstly, we’ve seen a major technological shift that has left both regulators and traditional businesses floundering. Secondly, low interest rates enable companies to borrow and raise money cheaply, with a focus on grabbing market share rather than immediate profitability. These two trends have been exacerbated by the flood of money into passive funds, which inevitably favour the biggest, most popular stocks.

The big question is: when might this change? Patience is a vital trait for value investors – but they may not have to wait too much longer. These factors are important, but none is permanent. And technology, the key “growth” sector, is now under pressure from regulators, trade wars, and – out of the blue – the effect of the coronavirus on supply chains. Meanwhile, as Keimling notes, in Europe the gap between the valuation of growth and value has only ever previously been this extreme at the peak of the tech bubble. “A more contrarian trade than value is currently hard to find.”

I wish I knew what an IPO was, but I’m too embarrassed to ask

An initial public offering (IPO) represents the first time that a company sells shares in itself to institutional investors (such as pension funds) and often also to individuals (retail investors). This process is also known as “floating” or “going public”. Companies go public for a wide range of reasons. They may want to raise funds for expansion and choose to do so by selling part of the company rather than borrowing the money. Alternatively, the current owners – perhaps the original founders, or a private-equity fund – may wish to “exit” (ie, cash in on their investment).

An IPO is underwritten by one or more investment banks, which typically earn large fees from the process. A prospectus with details of the company and the offering is issued to potential buyers. The IPO price is typically based on expected demand from investors.

If demand outstrips the number of shares on offer (the IPO is “oversubscribed”), then the underwriter will have to decide how to allocate the shares. If there aren’t enough buyers, then the underwriter agrees to purchase the surplus (hence the term “underwriter”). Occasionally – as with the very public disaster that was trendy office rental group WeWork’s attempted IPO last year , an IPO will be pulled due to lack of demand, but this is unusual.

More often, a newly listed company’s share price will enjoy a “bump” on the first day of trading. However, unless you are allocated shares before the company starts trading – which is unlikely with a “hot” stock – then you are unlikely to benefit from this initial jump.

Many studies suggest that IPOs underperform over the long run, although sometimes government privatisations (where the seller has less of an incentive to squeeze as much money as possible out of the buyers, who are, of course, also voters) can represent good opportunities (albeit sometimes only in the short term, as with Royal Mail).

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.