Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Why the value cycle has room to run
According to Pzena Investment Management, the value cycle is now truly under way – and shows no signs of slowing.
New York-based Pzena Investment Management began to track the value rotation in late 2020, with its analysis research showing that deep value stocks have outperformed by around 37.4 per cent since. But the question for Pzena is whether – amidst soaring geopolitical tensions, inflationary pressures, and the spectre of recession – that rally can continue.
And there have already been bumps along the road. But the average value cycle last around 62 months – five years – and results in 138 per cent outperformance. Ben Silver, portfolio manager at Pzena, believes that there’s no sign that this one will end any time soon.
“The current rally is only around 15 months long, with outperformance closer to 40 per cent – so we’re really only a quarter of the way there versus your average rally in history,” Silver said. “… But there are also plenty of periods where growth has outperformed in these broader value rallies. What we’ve experienced over the last year and a half or so is pretty much par for the course, and we still think we’re in the early stages of this rally.”
Of course, historical data doesn’t – or shouldn’t – imply anything about markets today. But valuation dispersion is wider today than at any other point in history, including the initial shock Covid market shock and the internet bubble. But that doesn’t mean value stocks are cheap. They’re certainly cheaper than anything else around, but the cheap stocks haven’t gotten cheaper – expensive stocks have just gotten more expensive.
“There’s close to $14 trillion trading at 10x sales. You can see how that looks versus most periods of history and how it looks against the internet bubble. And the performance from this is pretty poor; your average annual performance from buying or holding stocks at 10x sales is actually negative.
“Through this year, a lot of those stocks have come off; but there’s a bit under $10 trillion of companies at 10x sales, and it’s important to note that normally there’s less than a $1 trillion of company valuation at that very lofty spread. The valuation extremes are still there, they’re still real, and that’s why we think we’re in the very early innings of a value rally.”
Big geopolitical events are unlikely to kneecap the rally either. It’s “certainly possible” that Russia-Ukraine will result in higher inflation, drive central banks to raise interest rates and cause a knock-on recession; but Silver doesn’t believe that a recession means the value cycle comes to an end.
“(9/11) did not disrupt the value cycle that had started the prior year,” Silver said. “The back-to-back recessions in the US, 1980 and 1981 – the recession that started in 1981 did not disrupt the value cycle that started at the end of the previous year. We don’t know that this will lead to a recession, and even if it does it’s really not so clear that the value cycle will end anyway.”
