There’s no such thing as a dead cert in investing. Let asymmetry be your friend…
‘How can we be certain that we’re at the beginning of a value to growth rotation?’ a client asked recently.
Truth is, we can’t – no one can ever be certain of the future. That’s why successful investing is all about trying to skew the odds in your favour.
Buying businesses that are higher quality skews the odds in your favour because they can reinvest retained earnings at a higher rate than lower quality businesses
Buying businesses that are growing, skews the odds in your favour because revenue growth drives operating leverage.
Buying businesses with management who understand capital allocation, skews the odds in your favour because retained earnings are either invested or distributed to shareholders in a sensible way.
And buying businesses with strong balance sheets skews the odds in your favour because they aren’t being operated at the mercy of creditors.
BUT paying a low price is one of the most important factors skewing the odds in your favour because you get asymmetry.
If you pay a low price and the business doesn’t grow as fast as expected, or the quality of the business deteriorates for some reason or management make an ill-advised acquisition, or the cost of finance increases, there’s far less downside than if you paid a high price.
If any of these factors become more appreciated by the market or improve further, there’s far more upside from a valuation rerating than if you paid a high price which had already priced in all the positive factors.
That’s why we so strongly believe in the merits of value investing.
Zeroing in
Let’s take a quick look at history.
The last time value meaningfully outperformed growth (as measured by the total returns performance of the MSCI World Growth index and value indices) was after the dotcom bubble burst from February 2000 through to December 2006. Then we had 15 years of underperformance all the way to November 2021.
Yes, we had a few fast-growing tech companies, but the pricing of their growth was driven by low interest rates. This was a product of post-global financial crisis quantitative easing and low inflation in the West, itself the result of offshoring at a time of global stability and technological progress. Two-year US bond yields averaged 1.1% over this 15-year period.
The fundamental reason for growth outperforming value in a zero interest rate environment is simple maths: £100 of (forecast) earnings in 10 years is worth £100 in today’s money. But at a 5% discount rate, it’s only worth £61, almost 40% lower.
The problem for most investors today is that the environment is the complete opposite of those 15 years – we have quantitative tightening, higher inflation and interest rates, onshoring and global instability.
So then why hasn’t value outperformed growth in this new environment?
In fact, it has – over the past three years combined, value has returned 24% and growth 17%. This shouldn’t be a surprise: US two-year bonds have averaged 2.6% over the past three years and currently stand at 4.4%.
Variations on a theme
But this average hides huge variations. Value marginally outperformed in 2021 and beat growth by 23 percentage points in 2022 – but then underperformed by 25 points last year when the ‘Magnificent Seven’ tech giants put in a stellar performance thanks to the excitement surrounding AI.
Inflation may well be heading down around the world, but barring a complete economic collapse, interest rates are very unlikely to go back to zero again.
That era brought us cryptomania, special-purpose acquisition companies, meme stocks, huge venture capital spending and commercial real estate speculation. Central bankers are wiser now.
So if we want to skew the odds in the current interest rate environment, perhaps value is the way to do it.
History repeats
In the 12 calendar years since 1975 when growth beat value by more than 20 points (like 2023), value outperformed growth in every one of the next three-year periods by an average of 12.8 points. I really like those odds.
Now, we can all slice and dice history indefinitely, trying to guess what strategy will work best in our forecast economic environment.
But long-term history tells us that, ‘buying low and selling high’ is a timeless wealth creation strategy – regardless of any economic environment – and the odds tell me that’s especially true now.