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.
The value in value – it always wins out, eventually
In times of crisis value managers offer some comfort. They can see the silver lining, the light at the end of the tunnel, which other managers tend not to see. At this time of crisis, value managers, surely, after several years of underperformance, are about to come into their own.
In a note to clients last week, Pzena Investment Management, a highly regarded US-based value manager, says there are wider disparities at the moment, due to the financial impact of the coronavirus, than the firm has ever seen before in its 25-year history.
The client note says that value managers have beaten the rest of the market over every three and five-year period after major spikes in volatility. Even in the five years after the 1929 market crash, leading into the Great Depression, value posted an average of a 10 per cent a year return. The firm says: “Record uncertainty creates extreme opportunity.”
Pzena says that, in the first quarter, we had the biggest share market selloff in a generation, with volatility reaching its most extreme since the Great Depression. The MSCI World All Country Value Index was down 25.7 per cent (in local currency terms) in the March quarter, while the ACWI Growth Index was down 14.3 per cent.
“Across nearly all regions and sectors, valuation spreads are at or near the peak of their historical ranges,” the note says. “History has shown that the more pronounced the cycle, the more dramatic the unwind. In our view, this dynamic suggests that the outsized opportunity today is in value stocks.”
Value stocks sustained the worst-ever 21-day period in March, further extending the longest ant-value cycle in history. After analysing peiods of high volatility back to and including the Great Depression, Pzena shows that buying back into the market during the extremes of volatility has proved to be a good strategy.
“On average, simply buying the index during the last eight bouts of volatility has garnered investors a healthy 15.8 per cent return after one year and an annualized 13.3 per cent gain after five years. Value stocks have done even better, averaging a one-year profit of 28.4 per cent and a five-year return of 18.7 per cent, per annum. When the sellers become exhausted in a market rout, the cheapest stocks are difficult to ignore.”
The client note says: “If we are NOT entering an extended depression, the evidence suggests that value stocks stand to realize exceptional returns over the next several years. If we ARE embarking on another depression, based on the one example during the Great Depression, it would have still made sense for investors to buy value stocks, provided their holding period was long enough. The first of those five years would have been admittedly rough. However, attempting to time the market is a losing strategy.
“The likelihood that we are about to embark on a multi-year economic rout similar to the Great Depression should be considered low. Most economists agree that the policies employed in the 1930s exacerbated the problems, and current government policies are likely to be far more constructive.”
Pzena says: “We are in an environment where the dispersion between the cheapest and most expensive stocks across regions and sectors are approaching all-time records. In our 25 years of business, we have only seen this level of disparity once before. So, we are seizing this opportunity to add to the most undervalued companies in our clients’ portfolios.
“We have examined the effect that a severe downturn might have on all the companies in which we are investing. While we can’t be completely certain about the future, we see the risk of permanent impairment in our portfolio as low and the potential upside as exceptional.”
The manager was, at the end of March, strongly overweight emerging markets, slightly overweight UK and North America, but underweight Australia and New Zealand. Within sectors, the biggest overweight is to financials.
In Australasia, Pzena has offices in Melbourne, where country head David Taylor resides, and Sydney, where Paul Whymper-Williams works out of. Taylor said last week: “The value space has been particularly challenging in the COVID-19 market meltdown: the cyclicals, financials and then energy when the Saudi’s compounded demand side concerns with a supply side surprise!
“Markets still seem to be adjusting to the new economic order and not really focusing on valuation yet, but spreads are firmly on the value managers’ side for when they do… One of the most interesting observations was the data coming out of the Great Depression where, five years after the peak in volatility in 1929, value delivered plus 10 per cent per annum, whereas the market return was minus 10 per cent.”
– G.B.
