Whether or not we are witnessing the early stage of an end to the longest drought for value managers in history, history tells us that when the rains come, it will be a deluge. Recessions and their aftermath are particularly good for value managers.
At a client webinar organised by global value manager Pzena Investment Management last month (December 17), one of the 25-year-old firm’s earliest employees and co-CIO, John Goetz, said that since the end of September, there had been a “massive turn” in sentiment towards value, “but there is a lot of territory to cover”.
He said: “We think growth expectations should change after COVID. It’s all about earnings… “Expectations for earnings are higher for growth companies. Between 2016 there was a 30 points difference in annualised performance over the three-year period. During COVID, it went even crazier, with a gap of 80 percentage points.”
Interest rates have also influenced spreads “in all of history”, he said. But they don’t need to go up to reverse the style cycle, they just need to stop falling. Apart from some short-term spikes, interest rates had been falling for 40 years.
While the cheapest stocks have tended to be fairly stable, the most expensive – mainly large-cap tech companies – have become much more expensive, exaggerating the spread between growth and value.
“What’s not typical in the last three years is that there’s been a declining value for value stocks without rates going further down. It looks strange and if they change and go upward there will be a major catalyst for revaluation,” Goetz said.
Notwithstanding their gyrations, global stock and bond markets were good for investors last year. The S&P Global 1200 equities index was up 13.1 per cent for the year and the S&P 500 bond index up 10.2 per cent. Meanwhile, Global GDP slumped 4.4 per cent.
Pzena, and most other value managers, are currently pointing to the historical connection between recessions and the performance of value stocks. The average alpha for value in a recession, with data back to 1974, is 4 per cent and for Japan is 12 per cent. The outperformance of value against the market persists for at least five years after a recession, rising to 5.5 per cent for the US and settling at 10.5 per cent for Japan.
Emerging markets (EM) have followed a similar trend, although “emotional peaks” of value in EM can be more extreme, according to Caroline Cai, Pzena’s head of international portfolios.
“The valleys and peaks have always been sharper. When despair sets in, it looks more dramatic in emerging markets, she said. “It takes time for fundamentals to improve and show up but it’s not much difference between emerging and developed markets.”
Among emerging markets, China in particular has established itself as a technology powerhouse in recent years, but Cai points out that it is not true to say that incumbents in an industry are incapable of adopting new technologies.
Pzena points to the example of Volkswagen (VW) versus Tesla. VW, the largest carmaker in the world. It has invested about US$20 billion in investment electric vehicles (EVs), compared with about US$23 billion by Tesla. But VW already has four dedicated EV plants, compared with Tesla’s three. VW has five different models (Tesla four) and by 2025 will have 40 models (Tesla eight). VW has multiple brands to apply its technology and manufacturing capabilities to, including Porsche and Audi. VW’s free cashflow is about US$12 billion compared with Tesla’s US$2.7 billion. But the German company’s forward PE is just 6.0x compared with Tesla’s 156.0x.
With the better performance of value since October, helped by increasingly positive news on COVID vaccines, the gap between growth and value has only narrowed to the extent that value is back to September levels. There remains a long way to go.
There needs to be an exogenous event to change the momentum of markets, according to Goetz, and COVID has done that. “The catalyst right now is that relative momentum will shift to the companies recovering from quite a severe recession,” he said.
David Taylor, Pzena’s Melbourne-based Australasian head, said that dividends would “look pretty attractive on the other side of this if interest rates stay low”.