Value investing has intuitive appeal. Identify a company with a value higher than its current share price, buy, and wait. Eventually the short-term “voting machine” that is the market will recognise the value and the share price will rise accordingly. It’s a logical approach to investing for long term wealth creation.
There are two main problems. The first is the concept of valuation. Many investors believe that valuation is fact-based, as it is derived from the fundamentals of a company. There are many different ways to value a company, but all of them rely on estimates.
Whether it’s the guess at futures sales levels, or the assumed interest rate at which those sales are discounted back to the present, these estimates mean valuation is as much art as science. A valuation model is only as good as the underlying assumptions. Change an input, and the value of the company changes.
The high number of estimated inputs to valuation models means that a company’s “value” is much closer to opinion than fact.
But that’s not the main problem, at least from an investors’ point of view. In the bull markets of the last decade momentum investment has trounced value approaches. Many professional value investors have delivered below market returns. Value investing as a style simply hasn’t worked.
Worse, the markets are littered with “value traps”. A company releases bad news and its share price falls. After factoring in the bad news an analyst’s valuation is well above the current share price. Investors buy in, only to see further share price falls. More bad news emerges, but the company remains a “value” buy as the share price falls ahead of the valuation revisions. This can leave investors still clinging to shares that have fallen by 50% or more.
There is no single investment style that delivers superior returns throughout the market cycle. If there were, every investor would use it. As share prices are the product of crowd behaviour they are subject to the same forces that drive other areas of human endeavour. This means investment styles are subject to trends akin to fashions. At the moment value investing is out of style.
As the market cycle turns different approaches deliver better results. Value investing may be set for a resurgence.
An important reason to consider value based investing is the difficulties currently facing investors. They are trapped by easy money conditions, and asset values that are higher despite well-known concerns for the economic outlook. The flood of central bank stimulus funds must find a home. In a low cash interest rate environment this means investing in shares, bonds and property.
The challenge is that many assets are trading at or near all-time highs. At the same time there are fears that economic expansion is coming to an end. The current slowing growth focus is the trade disputes between the US and a number of other nations. However even if trade deals are reached this week it’s likely that fears of a downturn will persist, simply because of the length of the expansion.
This could partly explain the outperformance of more defensive sectors over 2019. Property and utilities are in favour with investors. These sectors are domestically based and have more transparent earnings. Investor preference for these less glamourous sectors could illustrate a defensive mindset.
If investors accept that growth fears will persist until the next recession are likely to retain a defensive approach. The impression is that investors are forced into the share market, and the choice of share reflects this dynamic.
This is a reason to think value investing will make a comeback as an investment style. In a defensive environment it’s much easier to buy shares that are nearer lows than highs. Defensiveness is a factor of share price as well as earnings profile. As economic worries build, value investing could return to fashion.
This article first appeared in the Australian Financial Review.
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