At the end of 2017 I wrote about the unusual-looking value on offer from our domestic stockmarket. Thanks to a mix of Brexit- and Corbyn-related hysteria, British equities were among the cheapest in the world.
I like cheap. So I suggested you take a look. I quoted Neil Woodford on the matter and suggested various domestic and value-orientated funds you could buy in the hope that the market began to agree. None have exactly covered me in glory since. Temple Bar, for instance, which I suggested and still hold myself, is down 30% in the past three years.
The only redeeming piece of advice I offered at the time was that I specifically told you not to buy Woodford’s flagship fund in your search for value – because of the unlisted stocks. It is now a year since that fund was suspended. The lessons from the whole debacle have been much discussed.
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Time is your friend – markets do revert to their mean
But if there is one that all investors should take away, it is to make sure that you invest in a way that gives you time. It was, you see, time that Woodford ran out of in the end. Given more of it, his private equity investments may have come good. Recent news that 19 of the holdings are to be sold to Acacia Research Corporation at least suggests that someone apart from him believes they are worth something. And his value plays (which he was already finding “uncomfortable” in 2017) almost certainly would have.
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Individual stocks don’t necessarily revert to the mean in any consistent way. But markets do – in the end – revert to valuation averages and to relative valuation averages. It’s a standard cycle.
Think about the relationship between growth and value stocks. People look at one group of stuff. They think they can’t possibly want to hold it because this and that is wrong with it. They can’t see how it can fix this or that – and it isn’t growing anyway. They look at something else, a bit newer and perhaps a bit shinier. There’s nothing wrong with it at all – and it’s growing. They must have it.
Then one day they look at the first thing and think, gosh that’s so cheap I don’t care about this or that any more. At the same time they look at the other thing and notice that there is something wrong with it after all – it costs too much.
At some point what you have to pay for a great and growing company matters more than the greatness itself. Now we are at the very end of one of these cycles.
Growth stocks have had a good run
The valuation gap between growth stocks and value stocks is “as stretched as it has been since 1904”, according to Edward Troughton of Oldfield Partners, a value-focused fund management firm. Growth stocks in the US have massively outperformed value since the global financial crisis and by some 20% this year alone. At the end of March, based on price to book, expensive stocks were about 12 times as expensive at cheap stocks (against a long-term median of 5.4 times). Extreme stuff.
One possible explanation for this might be that value stocks somehow represent worse companies than in the past. Not so, says Troughton. Numbers from AQR Capital Management suggest that if you look back at the cheapest 30% and the most expensive 30% of the largest 1,000 stocks over 53 years you will find that the gap in profitability between them is 14% at the moment, the same as its historical median. This is not a dynamic driven by a “previously unseen quality differential”.
You might also argue that this can go on forever. The scarcer growth is, the more you are prepared to pay for it. The lower interest rates are, the less you are bothered about the lack of immediate cash return from that growth. And perhaps our age of extreme monetary stimulus makes valuations irrelevant.
You can endlessly faff around finding academic justification for rising and ostensibly expensive equity prices at the moment. But is it worth the bother? As long as the central banks keep producing cash confetti, equities should keep going. Note that this week the European Central Bank announced a near-doubling of its corporate bond purchases to €1.35trn: EU equity prices obligingly leapt 2.2%.
Finally, you could say that in an age of lockdown many stocks deserve to be cheaper than usual. Who wants airlines, energy, cruise ships and commercial property?
In the long run, value wins out
You could be right. But before you start to feel too comfortable, two things to note. First, run the data back to 1825, as Two Centuries Investment has, and you will find that over the long run a value approach has outperformed – by around 3% a year. Second, value often outperforms as economies shift back from recession to growth – and the switch in the cycle could already have begun.
Airlines, casinos, cruise companies, energy companies – all the things the market has dismissed – are on the up. US airline stocks have risen 30% since Warren Buffett told us he was selling all his. Shares in Tui are up 63% from their May low. Shares in Shell are up 48% from their low. Shares in retail property firm Hammerson are up 180%. And my Temple Bar shares (which I am not recommending due to the manager change) are sadly still some distance from their 2017 level – nonetheless they are up 47% from their March lows. Phew.
A final stat for you. In 1904, value had been underperforming for 14 years and by 59%. This time around it is 11 years and 59%. It showed its best performance ever over the subsequent 16 years. Do you really want to bet on that not happening again? It may still not be fashionable enough. But I still like cheap – and I have plenty of time to wait for the rest of the market to like it too.
• This article was first published in the Financial Times
