Monthly Strategy Overview
During March the Pacific North of South EM All Cap Strategy outperformed the MSCI Emerging Market Total Return index by 4.5%. Our strategy continued to benefit from rotation out of expensive growth stocks and a renewed interest in value. While part of a global trend, this rotation has not yet been as pronounced as in developed markets – the MSCI Emerging Markets value index is only ahead of the broader index by 1.8% year to date, compared to a 4.3% outperformance in the S&P 500 equivalents.
Stock selection was the primary driver this month with most markets contributing positively but led by China, Korea and Mexico. The strategy’s underweight position in India was the only real drag against index performance. The strategy’s exposure to banks was particularly helpful during a month where rising US bond yields once again brought expectations of some recovery in net interest margins. Beyond this, a number of highly discounted stocks in the portfolio had a strong performance as investors sought out lower valuations.
We were fairly active towards the end of the month, in particular in reallocating within the technology sector – moving from some longstanding holdings that had performed well but no longer showed significant upside as a result, to those that remained highly undervalued.
Given the continuing run of relatively strong performance of value by most measures, investors are naturally asking how much there is still to go for value strategies?
While we always caveat that our approach differs from simplistic multiple based screens used for value indices, our portfolio does consistently exhibit strong value characteristics and of course benefits from such tailwinds.
Two key points to consider
First of all, it is important to stress that value investing is a dynamic strategy. Unlike growth investing which focusses on a fixed set of stocks that exhibit certain long-term growth trends, the universe of value stocks is constantly rotating as a function of share price moves. If a group of “value” stocks performs very strongly one quarter, there is a good chance that they will no longer be value stocks in the following quarter (but don’t necessarily become growth stocks as a result!). A new set of value stocks needs to be found to replace them. Similarly, growth stocks can simultaneously be value stocks – if they are inexpensive enough. What follows therefore, is that an active value strategy worth its salt should not find its portfolio becoming expensive just because many of its stocks have done well. The opposite is true of a growth strategy where valuation is not a factor in stock selection – it may well become overvalued as a result of sticking to its principles.
The second point is that value as a factor has over a decade of underperformance relative to the index to catch up. The long-standing practice of buying stocks and their cashflows at a discount has not worked for years – until recently. Cliff Asness of AQR recently published an interesting piece of research (The-Long-Run-Is-Lying-to-You) that statistically isolates what has driven that underperformance. It has not been due to the inferior earnings growth of value stocks but to the change in the market’s valuation of their earnings relative to those of growth stocks. This is of course backed up by the various studies showing the premium of growth stocks over value stocks at record levels. In other words, the market’s perception has been changing – rightly or wrongly – and this seismic shift has wiped out all alpha “normally” derived from buying undervalued stocks (and seeing them move towards “fair” value) by neglecting them in favour of growth and concept stocks.
Is this seismic shift complete?
We could suggest the pandemic and accompanying policy responses as a possible turning point, but actually this is not the real question. While nobody denies growth can be structural and therefore not mean-reverting (a fast growing internet company can keep growing – its business certainly doesn’t have to shrink back to its original size!), expansion of valuations absolutely has to be finite. An investor may consider paying fifty times today’s earnings for a fast growing business while ignoring a slow growing one on five times earnings. Perhaps one hundred times is also reasonable when the alternative are nominal bond yields of 1%. But what about two hundred times? Or five hundred times? Each time the valuation is ratcheted up, it becomes less likely that the same trick can be repeated – future returns can only come from earnings growth (for which you are already paying today!). The inference from AQR’s paper is that even if the past decade’s shift in relative valuations is justified and sustainable, simply sustaining it should not prevent value from outperforming.
This does not mean that the shares of an inexpensive telecom operator that has barely grown over the past 10 years will suddenly need to catch up with a decade’s worth of share price growth of a fast growing internet company. It could however mean that the prospective total returns of owning the telecom operator (high dividend yield plus some rerating towards more “normal” valuations) will exceed those from the internet company that has to spend the next three years growing its earnings to justify today’s valuation.
The market rotation we have been witnessing in recent months comes at the tail end of an unprecedented period of relative valuation changes. We have of course seen some of our value holdings re-rate to levels where we find better opportunities elsewhere and are constantly refreshing the portfolio as a result. What we have not seen however is a reversal or reset of the valuation discrepancies built up over many years. This gives us confidence in continuing to find opportunities to “add value” to the portfolio.