Back in January, we wrote a paper which underlined how thoroughly undervalued the UK stock market was versus its international peers. That hasn’t changed, if anything UK stocks are even more unloved by overseas investors and domestic fund buyers as the Brexit process rolls on.
Our focus is to offer evidence for our view that a dangerous bubble with historical parallels has formed in growth/low volatility stocks. Remarkably, this bubble has become so inflated that it has surpassed the TMT (technology, media & telecommunications) bubble of 1999-2000 in scale. This can be seen in the graph below, which shows the price performance of the MSCI Europe Growth index relative to the MSCI Europe Value index.
TMT bubble redux: the stark performance gap between growth and value stocks
Source: MSCI, FactSet, Morgan Stanley Research as at 30 June 2019.
Bombed out value factors, crowded growth and quality trades
If we drill down into individual factors, we see confirmation of how the incredible rally in growth has led to a marked bifurcation between value and growth stocks.
Based on the European equities universe, it shows that value factors (price-to-earnings, price-to-book, dividend yield and free cash flow/enterprise value) are hugely out of favour versus history. For example, price-to-book levels have only been cheaper 2 per cent of the time since 1995.
In contrast, quality, growth, momentum and low volatility factors are at extreme highs relative to their history. Earnings per share stability, for instance, has only been more highly rated by investors 1 per cent of the time. What is also noteworthy in this table is how bunched the values are at either end of the value/growth spectrum. One would normally expect to see a greater dispersion rather than this clustering at the extremes.
Value stocks now sit on a lowly 10.5x earnings on average while growth stocks are on 19.9x in comparison. A comparison of price-to-book values is even more stark: value stocks are on 1.24x their book value, on average, versus 3.86x for growth stocks.
This paints a picture of an extremely polarised market, one where value factors and value stocks have almost never been so out-of-favour, and one where investor demand for growth factors and growth stocks has almost never been so rampant.
This polarisation has become even more acute since May 2018, making for a tremendous performance headwind for value-oriented investors such as us over the last 12-14 months.
It is also rendering stock specifics less potent. Rather than good news triggering 10 per cent or 15 per cent share price gains on the day as we would normally expect, it is often being met with a shrug of indifference from a stock market that currently only prizes earnings momentum.
The new Nifty 50
Older investors or keen students of financial history will be aware of the so-called Nifty 50. This originally referred to a group of the 50 most popular New York-listed large-cap stocks in the 1960 and 1970s. Owing to the consistent earnings growth of these companies (household names such as Coca-Cola, General Electric Company and IBM), they became viewed as “one-decision” stock picks, because they could be bought and held indefinitely. Many investors were unconcerned by the premium stock market ratings that went hand in hand with the Nifty 50’s earnings momentum.
We believe a new Nifty 50 may be developing in the UK stock market. Five growth stocks (Diageo, Unilever, Relx Group, Compass Group and Experian) now account for 9.6 per cent of the UK stock market (FTSE All-Share Index) – five years ago they constituted 5.7 per cent of the index. These are all fine companies, but we do not own any of them. Besides not meeting our dividend yield criterion, we would argue that their valuations have reached dangerously high levels. Passive investors are being exposed to substantial valuation risk.
What happened to the Nifty 50? Well, they delivered what they promised, with their earnings rising but they dramatically underperformed the market over the 1970s. Indeed, the Nifty 50 did not recover their 1973 highs for the rest of the decade.
One of our fundamental tenets as investors is that investment success is determined by your starting valuation. The extortionate starting valuations of the Nifty 50 doomed these stocks to underperform, irrespective of how good these companies were and no matter how stable their earnings growth. Gravity-defying valuations for their latter-day UK stock market counterparts suggest to us a similar story could well play out over the next decade for Diageo et al.
Outlook – sticking with valuation, not momentum
Few investors that worked through the TMT bubble ever expected leadership and relative valuations within stock markets to ever return to the same extremes. Yet that is the point at which we find ourselves at the mid-point of 2019. How did we get here?
A combination of many factors have been at play, including nervousness about global growth/trade disputes, a view that global interest rates will stay lower for longer, technological change creating a perceived binary list of winners and losers, Brexit uncertainties and incremental flows into passives and ETFs. Whilst many market participants observe the current status quo as unsustainable, they also understandably question what will force a change in this dynamic in the coming months. Of the factors listed above, the one with most scope to change is the perceived risk around president Donald Trump’s Chinese trade agenda, particularly because he will increasingly have an eye on his own electoral cycle as 2019 progresses. Any sense of progress or even a less antagonistic dialogue could see a material shift in the bond market’s view on risks to global growth and commensurately the need for monetary policy easing. This would have big implications for leadership within the stock market.
In the meantime, we will continue to focus upon valuation rather than momentum, an approach that has served us well over the last two decades, even if it has reaped little reward in the last 12 months.
Clive Beagles and James Lowen are managers of the JOHCM UK Equity Income fund. The views expressed above are their own and should not be taken as investment advice.