In a report early last year, we analysed the argument surrounding whether value investing (a style that has significantly underperformed relative to growth investing) was about to make a sustained comeback. Simply put, value investing involves buying shares in companies that the managers believe are ‘cheap’ relative to the wider market and their own histories. Many value managers, however, will only buy ‘cheap’ stocks where they have pinpointed a potential catalyst they believe will lead to share prices increasing (by analysing metrics such as cashflow, leverage, balance sheets and external factors) in order to avoid ‘value traps’ - stocks that are still in a period of decline or worse, are heading for total collapse. Growth investing, again put simply, means buying companies that are displaying above average earnings growth. Most growth managers will follow a GARP (growth at a reasonable price) approach, which means they don’t mind paying higher than average valuations for a stock if they believe future earnings growth is undervalued by the wider market. In recent times especially, value investing has become synonymous with more cyclical stocks such as mining, energy and banks, while growth investing has meant a focus on more defensive companies (with futures which aren’t dependent on economic growth) such as utilities, telecoms, tobacco and other consumer goods stocks. Those who predicting that value stocks were on the verge of a new era of outperformance were proved wrong (or too early), as they generally underperformed growth over the course of 2017. However, in our report last year (and with the proviso that the past is no guide to future returns), we found that had been a correlation between the relative performance of value versus growth stocks and the trajectory of UK government bond (or gilt) yields, with value generally underperforming when yields fell (or when bond prices rose) and outperforming when yields rose (or when bond prices fell). Government bonds have delivered almost unprecedented risk-adjusted returns over the past three decades due to factors such as credit boom prior to the global financial crisis and ultra-low interest rates over the past 10 years. However, many believed bond yields would rise last year (as they did in 2016) as inflation picked up in the UK following Brexit-induced weakness in sterling, coupled with Donald Trump’s commitment to economic stimulus. However, despite these two strong forces at work, 10-year gilt yields fell from their peak of 1.54% in late January 2017 to 1.26% by the end of the year (representing a fall of c.20%). We don’t claim to be experts in global fixed income markets, but the commonly-held view among those who do, is that bond yields will rise over the coming years (though as we mentioned last year, many have incorrectly called the collapse of the bond market for a number of years now…). While this might not be repeated, and again like last year, our analysis shows that value stocks have historically outperformed growth when bond yields have risen. However, as we highlight in this report, it is surprising how little exposure the ‘average’ UK investor has to “value” as a style, with the large majority of inflows into equity funds heading towards funds with a clear “growth” or “quality” bias. As such, if this long-anticipated revival in value investing does indeed occur – most investors look likely to miss out, or worse, be hit by capital losses.
29 Jan 2018