2016 has seen an extraordinary rotation in equity markets, with leadership shifting from growth and earnings momentum to value. The underlying cause of this phenomenon has left many scratching their heads trying to understand what changed with the turning of the calendar.
It might be that the stretch between expensive and cheap just became too wide, that the first interest rate hike from the US Federal Reserve changed valuation models globally, or perhaps Chinese stimulus was what we needed to see resources and cyclical companies gaining favour?
It is hard to say, and it is not my intention to answer this question. Instead, I want to praise the virtues of value and to explain why there will always be an allocation within my portfolio to this part of the investment universe.
Performance of indices over 2016
Source: FE Analytics
Europe has long been a source of interesting value investments, with its diverse economies, where the de-industrialisation seen in the US and UK has been much less marked. As a result, European indices and portfolios often have a higher exposure to industrial and cyclical companies where value is most prevalent.
Smaller companies are no exception, and with a common misperception that all of Europe has been in recession since 2008 there have been ample opportunities to pick up value.
This leads to an often asked question as to whether value has any place in a smaller companies’ portfolio.
My answer is that all investments in an actively managed portfolio represent some form of mis-valuation by the market whether be it the under-appreciated growth company, or the excessive pessimism that gives rise to deep value.
This leads me to another misunderstanding surrounding the word ‘growth’; while many cannot see beyond the dynamic sales growth of immature companies, it is much more important to find companies that generate sustainable earnings and cashflow growth. Sales growth can be helpful but it is by no means the only source of earnings growth and what lies more within a company's control is their capital allocation and cost structure and how they influence earnings.
We all like to fool ourselves into thinking that we can predict the future with certainty but, beyond the short term, many events are difficult, or impossible, to foretell. Even though this lack of predictability has been empirically proven many investors are prepared to ascribe far higher valuations to companies whose survival, let alone success, is far from certain and way beyond our humble forecasting abilities.
So, if our job as stock pickers is to find companies where valuations are wrong, surely we should concentrate our efforts where our hypotheses will be tested in short order rather than those which will only be known twenty years from now?
If we as investors try to fool ourselves that we are masters of our destiny, we have nothing on the average chief executive who, by way of fighting their way to the top of the corporate food chain, will have developed a sometimes unhealthy level of belief in their ability to predict and control.
So just as we seek investments where mis-valuation will be revealed within a limited time horizon we should look for executives who ruthlessly measure and control all of the factors within their control and who avoid making grand forecasts about a long term that they are no better at predicting than the rest of the population.
Does this signify a lack of ambition on my part? My answer would be yes and no.
The next Facebook or Apple isn't hiding in my portfolio, but it is possible that the next Inditex or Ryanair might just be there. I am in awe of the individuals who create something genuinely ground breaking and, of course, those that create the winning technologies, new products or cure entire diseases deserve to be rewarded with high valuations.
Performance of fund vs sector and index since launch
Source: FE Analytics
My problem is that at the early stage for every winner there are multiple losers and often it is by chance that the eventual winner will emerge. I would rather back the company that is already established and where they, and we, can plot an incremental path to victory rather than the brave leap off a cliff in the hope that we are backing the exception to the laws of gravity.
This brings me to the two giants of European retail and short haul air travel that I referred to earlier. When I invested in these companies, I never stopped to ask where they would be in five, 10 or 20 years. Instead the conversation was about the here and now, where capital was being allocated and costs controlled. The route to greatness for these businesses felt, and continues to feel, like a series of brilliantly executed baby steps rather than the product of a grand Napoleonic plan.
Before I return to my natural habitat of smaller companies, there is one other mega-cap company where I think lessons can be learned for all investors and executives.
Google (or its parent group Alphabet if you prefer) is a revolutionary company which has certainly changed the life of this knowledge-hungry fund manager. What it has done to its corporate structure in the last few months echoes two of those factors that I referred to: predictability and valuation.
By splitting out its core business of search and online advertising from its big research and development projects of the future into the (interestingly) named Moonshots it has achieved two things.
Internally it can now control and explain its core business and continue to take further baby steps towards maturity. And, as for the Moon shots division, management now has a clearer idea of what is being invested and which of these unpredictable ventures might win (and which it might decide to cut its losses on such as the move into robotics).
For us as investors, we can decide what is the value of that existing business and what, if any, worth we should ascribe to the very unpredictable Moonshots division.
In conclusion, it is important to remember a few lessons: value is often treated like a dirty word but often value investments can deliver strong returns in a short period of time in a very predictable way.
Growth is great but we should not confuse ourselves in our valuation of it. As the realisation of high profits and cashflows becomes more remote, the greater the forecast risk and danger of exogenous shocks become. Quality helps as the growth horizon extends, investors can be shielded from some of this duration risk by executives that recognise that they should control the controllable and not make promises beyond their predictive powers.
This is why the Old Mutual Europe (ex-UK) Smaller Companies fund will continue to allocate to various buckets of return within the universe and why value will predictably remain a key element of this.
Ian Ormiston is manager of the Old Mutual Europe (ex-UK) Smaller Companies fund. The views expressed above are his own and should not be taken as investment advice.
