It is blindingly obvious that we live in a risky world. 
Politics are dysfunctional, geopolitical fears are intense, the global economic engine is spluttering and market volatility is terrifying. Investors could easily be forgiven for cashing in their investment chips, hiding their money under a mattress and hoping for calmer waters ahead.
We believe that would be a mistake. Alongside the myriad of risks, opportunities abound for patient investors.
In fact, we firmly believe that today’s investment environment offers the sorts of dislocations for investors to exploit what we last saw in 2011, and possibly as extreme as 2009, a subject we will elaborate on further in a forthcoming white paper.
Experience teaches us that fear and panic bring cheap valuations and a happy hunting ground for those who are willing to focus on the long-term potential that lowly valuations can bring.
This is absolutely the approach we are taking with our investment strategy and we are sticking wholeheartedly to our philosophy that the only key to long-term investment success is to buy cheap assets and hold them until they become less cheap.
Value always works?
To someone as simple as me, it is great to have trends that follow a similar pattern throughout history.
“Value” investing has consistently and considerably outperformed over the last one hundred years. There have been periods of long underperformance, such as in the 1930s, 1980s and more recently since 2007, but ultimately the results of buying cheap, unloved shares has gone on to be very successful.
Relative performance of indices since 2007
Source: FE Analytics
However, market performance over the last few years has led some investors to believe that the “value always works” strategy to be out of date.
Indeed, a recent meeting with a learned and experienced fund salesman piqued my interest, when he discussed an imminent fund launch, focussing on en vogue defensive growth companies with moderate dividends.
I declined his advances, as powerful as they were, and asked him whether at the same time there was an emergence of interest in their firm’s well-known contrarian “value” strategies. His response was that it appeared to him that investors just aren’t interested in such strategies and haven’t been throughout this decade.
What is “value”?
Before I discuss why such a strategy has lagged recently, I will elaborate on the common definition of “value” and what it means to us at Psigma.
The definition can be redeveloped over time, but at present, it appears to us that the terms “value” and “cyclical” have become almost interchangeable. Despite the recent abject performance of cyclical companies, 'cyclical' itself is not the investment swearword it is now commonly perceived to be.
Instead, it is simply the definition given to those companies that will be sensitive to swings in the economic momentum of their industries and end markets.
Energy, mining and industrial companies are obvious examples, whilst banks and many consumer companies are also painted with the cyclical crest. On the other side of the investment argument are the dependable 'defensives', areas such as utilities, telcos, consumer staples and many areas of healthcare.
Performance of indices over 7yrs
Source: FE Analytics
Such sectors have a higher predictability of earnings power, defendable dividends and, in many but by no means all cases, strong balance sheets. Simple analysis shows that the cyclical undervaluation relative to defensive areas of the market has never been more extreme than it is now.
Is this time different for value?
But why is this the case and should we give up any “value” investments we hold and say, 'hey this time it is different'?
Our answer would be an unequivocal 'no'. Given the extraordinarily fragile market conditions and heightened sense of panic investors hold, investors shouldn't ditch wholesale the recent jewels in their crown, but they should now pursue a better balance; given the dislocation and discrepancy between valuations that much is obvious.
Why the dislocation between value and growth?
Less obvious are the facts behind this unprecedented valuation gulf, but we apportion much of the blame on our friends the central bankers and their recent pursuits of major economic and financial system monetary experiments.
The collapse in official interest rates and market bond yields of higher quality sovereign bonds has destroyed the valuation anchor around which the prices of defensive companies hinge. Whilst the disinflationary mind-set hangs like a fog over the minds of investors, this might persist for a long time to come.
Indeed, it is our view that the pursuit of ever lower interest rates by central bankers is itself disinflationary and we are worried about the outcomes of the next round of European Central Bank and Bank of Japan meetings, where the respective governors seem set to push further on the piece of string by moving interest rates further into negative territory.
However, if we were ever to see signs of a normalisation of interest rates or confirmation that recent signs of a return of inflation were true, then an almighty period of rotation could take place, as the allure of the dividend on certain defensive stocks wanes.
2010 – 2015 - Defence = Good; Risk = Bad
The behaviour of the central banks has also possibly had another less blatant impact upon markets.
The market direction since the financial crisis of 2008 has been hugely dependant on the guiding hands of the masters of the financial universe and their latest announcement of monetary stimulus. This has led to extreme “risk on, risk off” moves and has not allowed normal trends to develop within markets.
Interestingly, the recent “baby steps” adopted by the US Federal Reserve has led to a period where specific corporate fundamentals have started to matter much more and there is clear evidence that certain “value” stocks have started to perform better, due to a combination of good earnings and cheap valuations.
Performance of indices in 2016
Source: FE Analytics
It is too early to call a return to a value summer because of one swallow, but a continuation of this trend would boost the confidence of those value investors who had been retreating ever further into their bunkers.
The scars of the crisis take a long time to heal
Another key factor is investor psychology.
In our view, the financial crisis of 2008 left lingering scars on the minds of investors who have pursued a “safety first” strategy. This much is obvious in the lowly yields available on many defensive companies, government bonds and high-quality commercial properties.
Investors are now paying up a ludicrous premium for safety, which we believe is unjustifiable and a risk in itself. Those dependable assets might well prove to be actually quite risky, were the value trend ever to reassert itself.
The big get bigger and their stocks get better
Finally, we believe that there has been a positive feedback loop in certain markets, where outperforming fund managers have been rewarded with inflows of fresh assets to deploy in their previously successful strategies.
The winning managers have got bigger and their influence has grown. In addition, the increasing use of “smart beta” instruments, particularly in Japan, has driven up valuation measures of those stocks that screen well for factors such as strong balance sheets and momentum strategies, thereby reinforcing the defensive outperformance trend.
Conclusion – Pursue a better balance
Equity markets around the world are as polarised as we have known them in the history of our business and we are excited by the rich seams of opportunity that are there are for us to exploit on behalf of our clients.
As we have seen over the last few years, value can ultimately take time to rise to the surface, but we believe that history should be used as a guide and ultimately contrarian value will be realised.
Of course, in a world where risks seem permanently high and there are plenty of “known knowns” and “known unknowns” to plague our working lives it would be wrong to solely pursue a deep value approach.
However, the major dislocation between growth and value areas of equity markets dictate that investors should reassess their positioning and create a better balance within their portfolios.
Tom Becket is chief investment officer at Psigma Investment Management. All the views expressed above are his own and shouldn’t be taken as investment advice.
