The value train has been touring the world over the past few months, with investors hanging off the sides in their eagerness to get on board. In this case we think it’s best to resist the fear of missing out and remain contentedly on the platform.
The S&P 500 Value index returned more than 11 per cent over the three months to November’s end — well ahead of the 6 per cent of its ‘growth’ sister index. There will be periods when the share prices of these sorts of businesses, which do better when economic activity picks up, will outperform, but we feel like they will be few and fleeting. For investors who resisted the urge to chase them, this has certainly paid off in the past. In the three years to 30 November, US ‘growth’ companies made 65 per cent, outstripping ‘value’ ones by 27 percentage points (see figure 1 below).
In a world of limited economic growth — a situation we believe will endure — it seems misguided to rely on accelerating economies to increase the overall pool of earnings. And, therefore, it seems misguided to buy ‘value’ companies that need reaccelerating growth to really outperform. Instead, we believe it’s prudent to stick with ‘growth’ companies that are doing business better than their rivals and taking in more earnings at the expense of competitors who just can’t keep up.
Sealing the deal
The recent rotation into value came after investors got excited about the chances of a ‘phase one’ trade agreement between the US and China, combined with some extremely early signs of a potential worldwide bottoming in manufacturing surveys. Both China and America flagged the high likelihood of sealing the deal before the end of the year, but then US president Donald Trump took to Twitter and the deal’s timeline dissolved. Similarly, you would need a magnifying glass to spot some of the upticks in economic data that got many investors excited.
Unfortunately, the more reliable economic indicators are sending only the most tentative of signals. Our own global leading economic indicator (LEI) troughed three months ago, but you can barely see the uptick on the chart (see figure 2 below) Both the six-monthly and annual trend rates are still firmly negative, and they have a more stable relationship with the performance of cyclical sectors than defensive ones. Other off-the-shelf indicators, such as the Organisation for Economic Co-operation and Development's (OECD) composite leading indicator for 23 nations, have yet to find a floor. Many of the indicators that are turning up are in some of the weakest parts of the world — Europe, notably. The Ifo index of German business confidence rose again in November, but it’s still consistent with GDP contraction in the fourth quarter, which we believe is unsupportive of a rally in cyclical shares.
Of course, we hope that the economic indicators have found their bottom, and that the uptick observable in many will develop into trends that can be followed. But a market strategy based on hope over fundamentals is a gamble.
When the pace of economic growth began to slow early in 2019 and the outlook became gloomier, we felt that it made sense for investors to start shifting their equity investments away from cyclical sectors and towards defensive ones. And that was the case even though we didn’t think a recession was necessarily likely to ensue. A difficulty we noted at the time was a lot of defensive shares looked a bit expensive, so you can see why investors might be clamouring for cheaper value stocks at the first signs of a recovery. However, our analysis found that in most cases, regardless of the initial relative valuation, defensive sectors tend to outperform during a slowdown. The risk of a global or US recession — and therefore a sustained slump in markets — is relatively low, but the cycle is just as likely to continue to slow as it is to accelerate. That means remaining invested but with a defensive bias.
Looking for value 
As long-term investors, we’re always looking for companies with the cash flows to invest in themselves and stay ahead of the opposition, regardless of the economic cycle. We won’t limit our search to companies that have a ‘growth’ label, or avoid others because they are labelled ‘value’. We look for businesses that have strong, reliable earnings that make it easier for them to adapt to an ever-changing world. According to a recent study by academics from the Stern School of Business and University of Calgary, the average large North American ‘growth’ company (top 30 per cent by market capitalisation) spends $1bn a year on research and development alone.
Many value companies simply may not have the spare cash to make the crucial investments in branding, research and development, automation, data analytics and bolt-on acquisitions that will help them tomorrow. In many cases, they have to use the cash to repay lenders or support short-term dividend policies to keep shareholders happy. The more uncertain the future for businesses, the more hefty the premium would-be investors are likely to demand for putting up their cash, so higher capital costs could make it uneconomic for ‘value’ companies to reinvest in themselves.
The North American study, which investigates the reason for the underperformance of value over the past few decades, made some interesting findings about the few ‘value’ companies that have managed to buck the value slump and turn themselves around. They had decent business models and lots of free cash flows to start with, which allowed them to borrow to invest heavily in plant and research and buy back shares, which reduces costly equity capital and frees up future cash flow even further. So, for a value company to do well, it must make radical investments in itself, probably financed by lots of debt, to catch up and become a ‘growth’ company. There are many risks there: over-leverage, poor execution and also the simple fact that a great escape plan could bankrupt a business if recession arrives too soon.
Over recent months, European stocks have staged a recovery as investors have looked to the region as a key value opportunity, seeing it as the final frontier of a 10-year economic cycle. But apart from a few great businesses that tend to be multinational and insulated from the most damning of Europe’s structural issues, we think Europe is likely to remain mired in low growth.
Rocket fuel for the 21st century
What about investment in the intangible assets that are the rocket fuel of the 21st century economy? By one estimate, northern European countries — the powerhouse of the eurozone — invest just $100bn to $200bn each per year. That compares with about $2trn of intangible investment in the US and $700bn in China. The US has been home to scores of world-beating companies of the kind that just don’t exist anywhere else. It seems reinvestment may be the ticket. There are relatively cheap companies out there that are not poor quality, just as there will be companies with a ‘growth’ label that are loss-making. But many value companies tend to be cheap for a reason, either because they are very cyclical, their earnings are hard to forecast, or they’re in sectors — like retail, old media, banks and energy companies — that are facing big structural challenges like disruptive technology, changes in consumer behaviour or climate change.
We believe that in the longer-term, growth is very likely to outperform value for the reasons we have discussed, but in the nearer term we recognise that macroeconomic conditions appear to turning more positive, and therefore one might look slightly more favourably on quality value names.
Julian Chillingworth is chief investment officer at Rathbones. The views expressed above are his own and should not be taken as investment advice.