Investors need to find an active manager with a sophisticated approach to identifying value opportunities if they want to beat the market over anything other than the very short term, according to Kepler Trust Intelligence’s Thomas McMahon.
The investment trust analyst said research shows that a pure rules-based value strategy hasn’t worked for many years and when it has worked it was isolated to certain segments of the market.
As such, he said a good active approach to stockpicking is key to identify the winning value opportunities
“We think investors need to be highly selective in choosing value strategies,” McMahon said.
“This is backed up by recent academic research, which points to the fact that simply buying what is cheap on a P/E [price-to-earnings] or P/B [price-to-book] basis is likely to be a losing strategy.”
McMahon said recent findings represent a warning sign against buying simplistic active strategies or value funds indiscriminately and may not benefit those who were hoping to use passives to gain access to value when the style starts to outperform.
Value investing has lagged behind its growth investing peer over the past decade, as the below chart shows, with a total return of 220.32 per cent over the past decade, the MSCI AC World Growth index has outperformed its MSCI AC World Value counterpart’s return of 151.90 per cent.
Although the trend was briefly reversed in 2016 – when the MSCI AC World Value index delivered a total return of 34.28 per cent compared with a gain of 23.18 per cent for the growth index – the gap between the two opposing investment styles has continued to widen.
Performance of indices over 10yrs
Source: FE Analytics
However, as the analyst noted, there are some signs that the froth is finally coming off the growth-led market, a reason why being selective will become increasingly important.
According to McMahon, recent academic research has found passive ratio-based investing is “unlikely to work”.
“Buying stocks which are cheap on a P/E or P/B basis without qualitative analysis of their prospects does not generate alpha,” the Kepler analyst said.
“Value investors aim to make money by buying companies when they are undervalued. However, companies can also be cheap because they are poor businesses and the market expects their earnings to worsen, in which case an investment would be a poor one.
“Research shows that simple rules-based strategies for investing in ‘value’ do not work because they do not discriminate between stocks which are undervalued and stocks which are deservedly cheap.”
McMahon said academics examined the returns to investing in the cheapest stocks on a P/B ratio over various time periods, using US stocks.
US growth large caps vs US value large caps over 10yrs
Source: FE Analytics
The results showed that buying cheap stocks on a P/B basis has not added alpha for many years but that the only time when this worked was when it was only due to shorting small-cap stocks, something McMahon noted is expensive to do when it is even possible.
However, he added, this doesn’t mean that value investing does not work, but only that active managers can make money from focusing on finding companies trading at lower prices relative to their fundamentals, as ratio-based investing doesn’t generate alpha.
The Kepler analyst said the poor returns to ratio-based investing is easily explained.
“There are two ways that valuation multiples such as price-to-book and price-to-earnings can mean revert. The first is that the price can rise and the second that earnings can fall,” he said.
“In the former case, the share price failed to reflect the earnings potential of the company, and the value investor’s investment was successful as the price rose to incorporate this information.”
In the latter case, he noted, the low price for the stock would have been proven to have been justified by poor earnings growth which will make an investment “a losing one” compared with simply “buying the market”.
“The analysis suggests that by buying low P/E or P/B stocks, investors are buying stocks with inflated earnings or book values, and the valuation metrics mean revert in a bad way – by earnings and book values being revised downwards,” McMahon (pictured) explained.
As such, what active investors are doing is identifying companies with inflated numbers and refusing to pay the same multiple for them as for their competitors or relative to their history.
This means investors buying ETF (exchange-traded funds) based on these rules could be considered to be tilting their portfolio towards “bad companies”.
He added: “The evidence suggests that active investors have created a market that is efficient in aggregate. It is not surprising to see that the alpha from pure rules-based values investing has ebbed in recent years.
“This suggests that the growing awareness of the efficacy of buying cheap stocks and the massive expansion of ways to access the markets for all sorts of investors in recent decades has led to an inefficiency being arbitraged away.”
He added: “It is clear that some active investors are capable of generating significant excess returns from following a value strategy.”