Disciples of traditional “Graham & Dodd” investing – Warren Buffet being the most notable – have had a tough time over the last ten years, as value stocks have consistently underperformed their growth and quality counterparts.
The problem is that, whilst value managers have sold a good story over the last few years, the cycle of underperformance has lasted a lot longer than I suspect most value managers would have believed. At a conference I recently attended in Edinburgh, one of the speakers stated that if you had been a value manager over the last few years, you either no longer have a job, or you no longer have clients!
Based on what we have experienced in the year to date, however, I see signs that the cycle in favour of value over growth is finally turning and if I am right, this cycle has much further to run. But why are we banging the drum now? After all, this is not the first time that value managers have pounded the table and claimed that the time is now. Simply put, we have needed a catalyst and, having listened to a fair number of meetings and presentations during my most recent series of fund manager visits in the UK, that catalyst appears to be inflation. (See Fig 1)
Value investing in its purest form can be seen as a short duration strategy, whereas growth, which relies on a stream of earnings far out into the future, is more of a long duration play. Low duration assets thus fare better in an environment of rising inflation, as higher interest rates have less of a negative impact on their valuations (this is not dissimilar to the argument in favour of holding short-dated bonds in a rising interest rate environment). Moreover, since value investments also tend to have higher debt levels, they are beneficiaries of higher inflation, as the real value of their liabilities is eroded more quickly. Rising inflation also tends to imply that growth will be stronger going forward and thus there is less demand to pay up for growth or quality immediately against a backdrop in which that growth starts to become less anaemic.
My argument in favour of value really rests on inflation starting to pick up again and whilst this is probably one of the most important variables we debate within MitonOptimal, on balance it does appear that the green shoots of inflation are appearing. Wage growth, particularly in the US, is on the up, evidenced by unemployment sitting at 4.9% and small companies struggling to fill jobs. Secondly, the rally we have seen in the oil prices will start to impact inflation and the Federal Reserve has recently been at pains to point out that the US bond market appears way too pessimistic on potential future rate hikes. Lastly, it is only a matter of time before capacity utilization levels start creaking, given the under-investment in capital projects by companies in over the last few years, thanks to central banks which have encouraged share buy-backs over growth in infrastructure.
To be clear, I am not arguing for runaway inflation, given the gargantuan debt levels globally which will keep a lid on growth. I do, however, foresee central banks being very loathe to raise rates, even when inflation starts to pick up and in this case, inflation might rise faster than the markets are currently pricing in. This ultimately favours value investing over growth.Winter is Coming...