When their share prices rise too high, even well-run, stable businesses can become dangerous to own. This is the view of Andrew Williams, an investment specialist at Schroders, who says a battle is raging between the forces of value and growth investing in global equity markets.
Value investing is when you buy a share on the basis of its good value (low price); growth investing is when you buy the share of a company that is growing rapidly (see “Definitions”).
He says although it may not seem like it at times, the fortunes of value and growth have been see-sawing for a long time. “Following what has become known as its ‘lost decade’, value enjoyed a marked shift in its favour in 2016,” Williams says. “This was not to last, however, and value surrendered much of its gains versus growth over the first half of this year.”
Williams says growth’s continued march northwards has been led by two distinct market sectors with little in common apart from a growing detachment between their valuations and history. They are the information technology sector in the United States (dominated by the so-called FANG stocks: Facebook, Amazon, Netflix and Google, now Alphabet) and the consumer staples sector in the United Kingdom and Europe. Williams says this year the gap between these highly priced shares and everything else has grown wider. He believes this high-valuation environment has echoes of the dotcom bubble in the late 1990s before it burst in 2000.
Williams says it is evidence of a classic behavioural bias where investors extrapolate current trends into the future.
“History suggests this cannot persist forever, and in the past a dislocation in the market, such as we are now seeing, has been a precursor to value outperforming, as expensive growth companies withdraw to lower valuations,” he says.
However, Williams cautions about reading this an invitation to time the market.
“Value investment is a long-term endeavour, and its performance could easily continue to suffer in the short term. That said, we would also point out that the investment style has displayed a consistent pattern of mean reversion over more than 100 years.”
Williams says that, given the scale of value’s underperformance, “we strongly believe its potential recovery could be the most attractive investment opportunity today’s markets offer patient investors”.
Searching for value
Not all sectors and markets are overvalued, however. In areas unpopular with the markets, some value-style managers are finding potential bargains.
When whole industries sell off – as has happened in the retail sector in recent years because of the progress of e-commerce – it tends to create a fertile environment for value investors, according to Juan Torres Rodriguez, a research analyst in the equity value team at Schroders.
“Markets tend to hate uncertainty – the worries that e-commerce is threatening traditional retail business models being a case in point – and that causes stocks to be sold indiscriminately, regardless of their underlying quality,” says Torres Rodriguez.
He believes value investors are well placed to pick up good businesses at bargain prices.
“That said, they also need to put their analytical skills to good use to ensure the risk-return ratio of any stock bought is attractive and there is a suitable ‘margin of safety’ should things get worse before they get better,” he says.
Beyond the obvious criterion of an appropriately cheap valuation, Torres Rodrigues says an important factor is the strength of a business’s balance sheet.
He says a retailer with a strong balance sheet – for example, in a net cash position or with a low level of debt – should have more time and room to adjust itself to the new e-commerce environment, allowing it to make the changes necessary to survive the tough times so it can prosper in the good.
Dan Brocklebank, a director of Orbis, Allan Gray’s offshore partner, also sees value in stocks that are being shunned for various reasons.
“While sentiment swings, we do fundamental, bottom-up research on a company’s long-term potential, and have found a number of attractive opportunities within emerging markets,” Brocklebank said, speaking on the sidelines of the Allan Gray Investment Summit held recently in Johannesburg.
He said South African investors can take advantage of these global opportunities if they avoid following the herd and resist the temptation to rush towards the so-called safe havens when things appear to be shaky. The US health sector presented one such opportunity, as President Donald Trump’s threat to “rip up the rulebook” for healthcare spending had created a lot of uncertainty and negative sentiment within the sector, he said.
Orbis has also identified a number of companies in the global e-commerce space, including JD.com in China and MercadoLibre in Latin America. “We think what’s missing is that the shift to e-commerce is such a long and gradual process that these companies are not pricing in their long-term potential,” Brocklebank said.
Growth share: the share of a company that is in a high-growth phase, employing the bulk of its profits to expand, rather than pay dividends to investors.
Value share: A company whose share price is lower than the fair value of the company, meaning it presents a bargain for the investor. A share’s valuation is normally measured by its price-to-earnings (PE) ratio.
Mean reversion: a theory that share prices that deviate from the long-term average, by being either too expensive or too cheap, will eventually revert to that average.