Why we still believe in value investing

Value is a broad church capable of embracing a variety of investors within its congregation. That said, we do believe it is stretching the argument to suggest that merely buying an asset today because you think it will be worth more at a later date is, by itself, enough to make you a value investor.

That distinction arose during a panel debate I took part in last month for London Business School’s annual asset management conference. The session bore an increasingly familiar title - ‘Is value investing dead?’ - and we will come onto that question later. First, however, the moderator wanted to go back to basics - how do the panellists think about value investing and why do we believe in the discipline?

On the first point, ‘classic’ value tends to involve using a preferred valuation metric - be it price-to-book ratio, cyclically adjusted price/earnings (Cape) ratio or whatever - to filter or screen a particular universe of stocks so you are looking at, say, the cheapest 20% or 25% of the market. Importantly, though, this is where you will also find a disproportionate amount of emotion – primarily fear and distrust.

The behavioural idea of ‘loss aversion’ - or, more formally, ‘Prospect theory’ - suggests people generally feel losses twice as much as they feel gains, which in turn suggests the cheaper an asset becomes, the greater the emotion surrounding it and thus the greater the scope for mispricing. To take advantage, value investors have to be prepared to do what other investors, for whatever reason, do not, will not or cannot psychologically.

The other side

Value investors therefore need to be willing to take the other side of that trade - but, of course, no matter what your screens are telling you, it is incredibly challenging always to have to do what the great majority of people in the market do not, will not or cannot. It is this behavioural element to which I always return when asked, as I was in the panel session, why I continue to believe in value investing.

Ultimately, when investors start talking about politics, thematics, macroeconomics and so on, it is very easy to go around in circles or to make forecasts, which is effectively just a sophisticated word for ‘guesses’. The truth is, however, over a long enough period of time - 100 years, say - you will see every political environment, every thematic switch and every macroeconomic backdrop.

Structural change happens too - cars, televisions, aeroplanes, the internet... everything changes. Well, almost everything. As we have argued in pieces such as Why value works, ultimately the only thing that never seems to change is the human element. Some might argue human beings are far more rational now than, say, 50 years ago but we do not see a huge amount of evidence to support this view.

In fact, if you look at the patterns of behaviour visible in markets - stockmarket cycles, for example, or the waves in company mergers and acquisitions - they remain pretty consistent. As does human behaviour. There is an old adage that, in the short term, investors learn a lot; in the medium term, we learn a little; and, in the long term, we learn almost nothing - and value investing is effectively looking to exploit that.

Extended cycles

That said, there are some solid reasons for thinking value cycles have now become extended - not least lower-for-longer interest rates. If we disaggregate the justification for paying higher valuations for growth stocks with a discount rate and simply focus on what ultra-low discount rates and risk-free rates have done to extend the market cycle, it has been very powerful - and very negative for value.

Furthermore, the lack of mean reversion in the profitability of the average company has been pretty extraordinary too - for example, over the next 12 months, US businesses again look set to bounce back to all-time highs of profit margins. So some of the elements value investors might have expected to play out in a more regular way have undeniably become very extended.

One final point worth making here is on the power of narrative. It used to be you could be paid off as a value investor simply as a result of the short-term nature of markets - in other words, most investors would trade a company on its current earnings rather than wait five years for it to recover. As a value investor, however, you would ultimately profit from being patient and trading on that business’s five-year earnings.

Yet today, with a lot of businesses, the market is learning to look through market cycles - airline valuations being a case in point - and the narrative is what really counts. If your business has a bad narrative - one of negativity, structural disruption or change - then it will see very little in the way of multiple, whether it operates as an oil extractor, a mail operator, ‘old tech’ or whatever.

That is where you see the fear and the distrust - the worry there is no mean reversion in the stars for these businesses - and, quite often, that is the side of the trade value investors are being asked to take. Of course you need to be very careful because ‘there be dragons’ - some businesses really are undergoing huge change and you will indeed see no reversion. Yet, on average, in many cases, you will. There lies a big opportunity.

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