In this article, James Inglis-Jones looks back at the rally in value stocks over the last year, explains why and how the Cashflow Solution investment process was able to benefit from this trend, and asks whether value outperformance has further to run.
The backdrop: more than a decade of value underperformance
While its long-term track record is excellent, value as an investment style has underperformed massively over the last decade. The extent of this poor performance is illustrated in the chart above, which we’ve run through to March 2020. The chart, based on Kenneth French’s dataset at Dartmouth, illustrates the remarkable fact that value has suffered its worst decade of returns in 70 years.
Strategies that endure this kind of return typically suffer from significant capital flight and fund closures – certainly, it’s the case that returns to value had been so bad that people were starting to question its ongoing relevance as an investment approach.
Traditional measures of value include a broad range of balance sheet asset ratios such as price-to-book and income statement measures such as the price/earnings ratios. Our assessment of value is instead tethered to cash flows – a more relevant and accurate yardstick we believe of the value opportunity.
However, for several years our investment process had been leading us to prefer companies with strong cash flow growth prospects rather than those with value credentials. As a result, our portfolios had a long-standing negative exposure to value as an investment style when viewed through the prism of fundamental factor risk models.
But, like many practitioners, the speed and scale of the Covid-19 sell-off last year took us by surprise and was not anticipated by our investment process. Immediately prior to the Covid-19 crisis, we held a constructive view of equity markets: although markets had become more expensive after strong returns in Q4 2019, valuations didn’t look worrying and companies in Europe were not showing any signs of over-aggressive levels of investment, which tends to be a positive indication for equity markets. Whilst we owned some cyclical value stocks in our portfolios, we also had a number of stocks we would characterise as quality growth stocks that looked expensive on conventional value measures but were attractive owing to their tremendous cash generation – good examples were Novo Nordisk and Simcorp.
Covid-19: value capitulation presents investment opportunity
Whilst value investors may have felt like they had endured a rough time prior to the pandemic, the sell-off in markets in March 2020 dramatically increased their pain. Value stocks were hit extremely hard while many growth stocks – particularly those seen as immune to the economic impact of Covid-19 – fared relatively well.
With lockdown measures enforced globally, many businesses were severely restricted in their ability to trade, with traditional value stocks – often reliant on a physical presence or face-to-face interaction – among the most obvious victims.
However, whilst shocked at the speed and severity of the sell-off, Samantha Gleave and I noticed that our investment process was beginning to highlight a significant opportunity. Specifically, there were two indicators that we monitor closely that were signalling the need to steel ourselves to fundamentally re-shape our portfolios with a heavy emphasis on cash flow valuation rather than growth – the mainstay of our stock selection for the last several years.
Our investment process was telling us loud and clear that, rather than fleeing the value space, investors should actually be embracing the risk found in these much-maligned stocks.
The first, and simplest, of our investment process signals pointing to an upbeat outlook was market valuation. Here, we were looking at our own measure of share price valuation based on ‘through-the-cycle’ measures that use average cash flows over a multi-year period. On this purely quantitative, backward-looking measure (that made no predictions about Covid-19’s impact) stockmarkets had slipped to very cheap levels.
When markets rapidly downtrend into such anomalously cheap territory, our historic analysis suggests that they tend to rebound swiftly to generate excellent one-year returns, albeit often with a lot of volatility along the way. We also knew from our analysis of historic recoveries – going back to the 1920s – that these sharp rebounds have almost always been led by value.
We have been aware for many years that value recoveries are often extremely difficult for investors to capture, mainly due to the psychological pressures an investor feels at the depths of a sharp sell-off. As a result, several years ago, we developed a measure of investor anxiety or stress. We reasoned that very high investor stress levels were likely to be the starting point for value recoveries and developed an indicator of this stress not only to highlight these opportunities but also to force us to act against our natural instincts to seek safety at moments of high stress.
We spent a significant amount of time developing this investor anxiety indicator having been chastened by our failure to participate in the resurgence of value styles in the aftermath of the 2011 plunge in markets. Back-testing of this measure did indeed show that the time to embrace value and be contrarian was always at times of high investor stress. We noted from the historic record that the returns to value strategies at this point were spectacular and very painful for investors who failed to participate.
This investor anxiety indicator last year surged to very high levels that had only been surpassed during the global financial crisis and technology bubble, episodes which set the stage for powerful value rallies.
When investor anxiety is high, it’s natural for investors to gravitate towards perceived safer bets: defensive growth stocks such as the UK’s consumer staples conglomerates Unilever and Reckitt Benckiser, or pharma giants AstraZeneca and GlaxoSmithKline. This results in widening valuation gaps between the popular, expensive stocks and the out-of-favour cheaper value shares.
The best approach to deploy in these environments is therefore to buy the very cheap stocks that have been shunned by investors, even though at the time this feels fraught with risk and danger. Specifically – and as classified by our proprietary stock designations – it pays to identify ‘Contrarian Value’ or ‘Recovering Value’ opportunities. These groups include companies that are responding to tough trading conditions with measures such as the imposition of capital controls, asset disposals and other restructuring measures.
In effect, the Covid-19 market sell-off had delivered a perfect storm for value investors: an extended multi-year period of underperformance, followed by a market rout in which value stocks plunged the most, and a severely uncertain outlook for the ability of many of these companies to operate.
Investors were being offered a hefty premium to take on risk and uncertainty in the form of bombed-out value shares. When the level of premium on offer is of the type we saw in Q2 2020, it is almost always the right thing to do to take on the risk and uncertainty of a more valuation-based approach. By contrast, growth and momentum strategies – and in particular companies seen as immune from, or even beneficiaries of, the pandemic – looked very expensive consensus positions that we were concerned about.
Having the confidence to be contrarian
The problem is, doing the ‘right thing’ isn’t always straightforward. Reflecting in hindsight on the environment in April last year, it was clear many investors were avoiding value stocks for a reason: no-one knew what the short, medium or long-term impact of the pandemic would be. In such circumstances, most investors find it rational to pay a large premium to hold stocks that seem most resilient to extremely challenging circumstances.
As Samantha and I considered how to reposition portfolios for this environment, we found that a lot of people we spoke to were very apprehensive about taking on significant value exposures at this time. When faced with this kind of emotional pressure, it can be tempting to find safety in numbers and follow the herd. In such situations, I take great reassurance from the long-term empirical work we have done, testing and re-testing our investment strategies against historical data sets.
Our investment process was telling us that sheltering in expensive stocks that had been resilient to the sell-off was exactly the wrong thing to do – the outlook for crowded trades and momentum strategies was very concerning and it was in fact this strategy that was the high-risk dangerous trade, not value. Periods of very high investor anxiety almost always set the stage for feared ‘momentum crashes’ – periods during which the stocks that have delivered strong relative performance do badly, whilst stocks that have delivered very weak relative returns perform extremely well.
We know that the Cashflow Solution investment process can deliver its strongest returns during bouts of market inflection and it is essential not to miss these turning points. Luckily, both Liontrust and our funds’ investors share the conviction we place in our investment process, allowing us to take a bold contrarian position.
Selecting the most attractive contrarian positions
To help us identify the most attractive contrarian value stocks, we deployed a proprietary crowding score. This measure combines a variety of factors including price performance, valuation and analyst sentiment. We were looking for true contrarian stocks – those with low crowding scores, that were hated by analysts and not widely held by investors, resulting in depressed share prices.
Unsurprisingly, in the midst of global lockdowns, downtrodden value sectors such as autos, travel, financial and media loomed large in this category. These value stocks had excellent backward-looking cash flow yields as a result of strong historic cash generation combined with share prices that had been among the worst affected by the pandemic. It was not uncommon to find stocks that had fallen into this category down by 80% or even 90% in the sell off. Investors were reasoning that these stocks faced severe operational challenges and were likely to see their earnings collapse as the economic downturn took hold. However, we reasoned that, yes, such companies were likely to suffer in the short term but were just as likely to see their cash flows revert to more normal levels as economies recovered in time from the pandemic.
November 2020: The vaccine rally
We had prepared ourselves to be patient for these contrarian value investments to pay off as the world got to grips with the pandemic, but November 2020 revealed a step-change in this process. As news of potential Covid-19 vaccines broke, there was optimism that the recovery might now be in sight and we witnessed a significant factor rotation in value’s favour. At the same time, we saw the biggest one-day momentum crash in history after the positive vaccine announcements by BioNTech/Pfizer and Moderna.
The start of 2021 appeared to show an ebbing away of this value strength. This trend coincided with an intensification of Covid-19 second waves in many counties as new variants emerged, resulting in more stringent lockdown measures being re-introduced. However, since the middle of February we have seen another marked upturn in the strength of value shares relative to their growth counterparts.
Due to the success of vaccination programmes in many developed markets, economies are beginning to be released from lockdown restrictions. Improving economic activity has been visible in both macro data and corporate updates.
At the macro level, this economic recovery is being reflected in a rise in bond yields, albeit from extremely low levels. An ongoing rise in bond yields would represent the removal of a key headwind to value investing that has been in place during its decade of underperformance. Valuation models for growth stocks are very sensitive to the discount rate of their future assumed high growth. Low yields make growth companies look more attractive relative to value stocks but rising yields quickly erode the present value of future growth.
At the corporate level, several of the Fund’s holdings have shown evidence of stronger trading in 2021. Danish jewellery retailer Pandora is a great example of a portfolio holding that has ridden the value rollercoaster over the last year. We added shares in the company to portfolios in April 2020 after a sharp share price fall had left them looking very attractive on our cash flow scores on a value basis.
Although appearing vulnerable to lockdowns due to its large physical retail presence – it has over 7,000 points of sale – the company soon issued a reassuring first quarter statement explaining that it had enough liquidity to sustain a scenario where all its physical stores remained closed the rest of 2020. Its operations were heavily affected by lockdown measures; in April 2020, Pandora had only 20% of stores open but this had risen to 86% by the end of June, while online sales growth doubled during the year. Overall, Pandora suffered only an 11% organic sales contraction in 2020 and largely outperformed investors’ expectations of the company during the pandemic. Although experiencing declines year-on-year, it remained heavily profitable and cash generative: it recorded operating profit of DKr2.68bn and free cash flow of DKr4.9bn on revenue of DKr19.0bn.
Despite closures of around 20% of its stores, Pandora stated in March of this year that it still expects 2021 to see a return to organic growth, forecasting an increase of more than 12%.
Peugeot is another great example of a value stock we were able to buy at the height of investor anxiety around a year ago. The outlook for the French carmaker seemed troubling in April 2020 as European new passenger car registrations tumbled 80% year-on-year.
But its shares were boosted by a merger with Fiat Chrysler and the prospects of a recovery in vehicle sales. New passenger sales in the EU in March 2021 rebounded to 87% above their levels of a year earlier. Stellantis (the new, merged entity) recently stated that it expects to improve margins in its first year as a company. Adjusted operating margins in 2021 are expected to be 5.5% to 7.5%, up from 5.3% in 2020, as management focuses on achieving merger synergies
Is this a temporary blip in growth’s dominance or is there more to come from value stocks?
While value stocks have served our portfolios very well over the last year, the cohort on aggregate – as defined by MSCI indexes – has barely dented growth’s superior medium-term performance. As we recently re-shaped our portfolios to reflect the latest cash flow trends in the market, Samantha and I considered whether value’s recent outperformance has further to run or is already done and dusted.
Starting first with aggregate equity market valuations, we found that – in contrast to this time last year – they are no longer cheap. In fact, so strong has been the performance of equity markets in the past year that European markets are looking expensive relative to history. In addition, our proprietary measure of corporate aggression is providing some warning signals. It has begun to climb quite significantly – a reflection of boardroom enthusiasm regarding the prospects of economies re-opening and equity and debt issuances executed during the pandemic.
However, while we have become more guarded in our overall outlook for equity markets, we remain convinced that the performance of value as an investment style should continue to be strong.
There are three reasons for this. First, the majority of the high valuation of stockmarkets is attributable to the expensiveness of growth and quality stocks. Value stocks by contrast, despite the strong rally of recent months, are still priced cheaply relative to history.
Second, value stocks now have momentum. A year ago, making a value bet in a portfolio meant a negative bet on momentum as the strong momentum cohort was dominated by growth stocks. This is no longer the case today – indeed our portfolios have strong biases to both value and momentum whereas a year ago the momentum bet was strongly negative. This is a development in the world of factor investing that has not occurred for a number of years and is highly positive for value’s prospects – we noticed that when value stocks also carry a strong momentum signature we were unable to find in the history a period when value did not perform strongly.
Finally, we would point to the sheer scale of the underperformance of value in the last decade. Value has a lot of catching up to do as the chart above makes clear. Whilst it may seem as if value stocks have had a strong six months, they have merely begun to mend the devastating performance they have delivered to investors in recent years.
We suspect investors may continue to be sceptical of value’s prospects. Whilst value has proved a challenge to some of our most successful peers in the short term, it may be tempting to assume that growth will simply recover its poise to re-assert its dominance. We remain sceptical of this view for the reasons outlined above and would at this point be particularly concerned about the prospects for growth investing.
Growth stocks today remain on extreme valuations relative to history. Because momentum was underpinning growth stocks in years past, valuation was much less of a concern for us. However, we would caution at this point that the combination of high valuation and poor momentum is usually a recipe for disappointing outcomes. We have also noted with interest that the signals we use to guide us in the management of our short positions are telling us today to increase our short positions in this cohort of expensive stocks with high growth forecasts and bad momentum in anticipation of poor performance ahead.
Key Risks
