SSgA CAPITAL INSIGHTS VIEWPOINTS Part of State Street s Vision thought leadership series Cheap for a Reason Finding Value in Uncomfortable Places. % 1.5 % Why Value Investing? Two numbers that cut to the heart of the value investment philosophy and provide a snapshot that tells the story better than a thousand words. by Barry Glavin, CFA Chief Investment Officer, Fundamental Equities and Brian Routledge, CFA Head of Portfolio Management, Fundamental Equities There is a fundamental simplicity about value investing that underpins how we and other investors with a similar style build equity portfolios. We spend our time seeking to buy stakes in good quality businesses that we understand, for significantly less than they are worth. In this article, we introduce the concepts that provide the foundations of our investment discipline, illustrate how adhering to it has delivered over time, and reflect on an interesting development that we have observed in our portfolios in recent times. To say that we buy undervalued stocks is a very simple statement. It has been said before by many others in many different ways. But we re comfortable with the fact that the statement lacks originality. Our experience, and more importantly the data, suggests that this approach to investing delivers. As pragmatic investors, we have never had the urge to invent a new methodology. Our preference has been to adopt a proven approach, and then focus all our energies on the task of actually implementing it and that task is formidable. Professors Fama and French, in their well-known and wellregarded study, identified what they described as the value/ growth premium. This is the annualised excess return of cheap stocks over expensive stocks in the US equity market over a 85-year period 1. This outperformance is not isolated to the United States as Marsh, Dimson & Staunton s research into global equities established a similar figure. A casual comparison of the total return of the MSCI Global Value versus the MSCI Global Growth indices over a period of nearly years since inception reveals a number that is consistent with the aforementioned studies. We ve always wondered how such an anomaly has endured, failing to be arbitraged away by a well-resourced industry aiming to maximise returns. Our answer of convenience has long been that buying cheap stocks is more difficult than it sounds, and despite many attempts, that s the best explanation we ve come up with so far. Contrarian Thinking As a firm, we and our predecessors at Bank of Ireland Asset Management have spent four decades attempting to ignore the trends of the day, and focus relentlessly on the price we re being asked to pay for each individual stock. This inevitably leads us to areas of the market that are not of interest to others, to invest in companies that others don t want. If this is relatively straight forward, if not easy, then not buying expensive stocks can be surprisingly hard. Over time, the firm has developed an investment culture that has embraced the discomfort of adhering to this discipline sometimes under extreme pressure.
Figure 1: Japanese Equities Price/Book Value vs. Global Benchmark P/B 5 1 Dec 197 Japan Nikkei 5 hits 9, Tech boom fuels market values 198 199 May 1 MSCI Japan MSCI World Source: Factset, MSCI Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Figure : Tech stocks saw more extreme P/B values P/B 1 1 1 8 Jan 1995 MSCI World IT MSCI World When growth expectations detached from reality Tech stocks still trade on higher P/B than market, but premium is smaller 1999 8 May 1 Source: Factset, MSCI Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. The most obvious examples are unsurprising. In the late 198s, our global equity portfolio held no Japanese shares. At a time when Japan s stock market accounted for up to % of global equity benchmarks, it represented a considerable contrarian stance. The positioning was born out of the simple fact that our research could not unearth a single stock that satisfied our investment criteria, such had been the run-up in the stock market during that period. When one looks at the chart of the Japanese market during this period (Figure 1), it might appear easy to conclude that it was a straightforward call, but hindsight is not readily available in the heat of bubbling markets. Nearly a decade after the Japanese experience, shares in technology companies took off. Again, the valuations on offer dictated that our portfolios didn t participate in the astonishing rise of the technology sector (Figure ). As with the Japanese example, not owning a huge swathe of the market that was on a winning streak put the team, our clients, and the firm under significant pressure. Again, it took time for this to prove a wise decision. As Chris Reilly, our long-standing CIO of the time, remarked you have to stick to your guns, although its hard when everyone is telling you the world has changed and you are a Luddite. We mention these two examples, not simply to cherry-pick those decisions that worked out well there are others that were not as successful but because they raise a couple of points that are interesting in the context of today s opportunity set. In both examples, a disciplined, long term, patient approach was crucial to a favourable outcome, underlining the importance of having time on your side as an investor. During these periods, the subset of the market that was out of favour, and therefore our hunting ground, included low beta, stable, defensive stocks and it is these characteristics that stand in stark contrast against the types of stocks which we believe offer value today. The efficient market hypothesis would have it that financial markets find their equilibrium as investors swiftly integrate all relevant news and data into stock market prices. It would seem, over the years, that more and more information is driving more and more investment decisions. Looking back over the last 5 years, the average holding period of stocks on the New York stock exchange has compressed considerably from about seven years to about seven months (Figure ). Figure : Average Holding Period on the NYSE (Years) Years 1 1 8 You have to stick to your guns, although it s hard when everyone is telling you the world has changed and that you are a Luddite - Chris Reilly 19 19 19 19 1988 1 Source: NYSE Factbook
It is not clear to us that this has led to more efficient markets. It is hard to see why, if one s holding period is less than seven months, long term earnings power could be a factor in an investment decision. If one s investment horizon is a couple of quarters, long term value is irrelevant. Investments that are unlikely to deliver immediately are surely of no use to such investors and this in turn should create opportunities for those seeking long term value. The opportunities manifest themselves in the anomalies created by all this activity companies whose share prices become dislocated from their long term earnings power. Against this backdrop, being in a position to invest on a multi-year timeframe offers a distinct competitive advantage. Our experience is that outcomes are more reliable over the long run, as share prices capture the fundamentals of a business. In the short run, prices seem to be set by transient issues and shifts in sentiment. Indeed, in this context, would it be reasonable for one to question whether volatility is any longer a measure of risk, or merely a measure of the rate at which investors change their minds? Counter-intuitively, absorbing volatility may in fact be a method of ensuring a more reliable outcome, thereby reducing risk. The Value of Patience If one can combine cheap prices with a long term investment horizon, investment outcomes would appear less random. If we observe the history of the MSCI World Value Index versus that of the MSCI World Growth Index over rolling six month periods, close to today s average holding period, the relative performance looks like this: Figure : MSCI World Index minus MSCI World Growth Index -Month Rolling Returns (%) 1-1 - - Jun 1975 MSCI World Value Outperformed Growth MSCI World Growth Outperformed Value 198 1991 1999 7 Apr 1 Source: SSgA & MSCI, as of 1 May 1. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. The data sends a very clear message. While cheap stocks deliver excess returns over time, returns are volatile and lumpy over short periods. The dilemma facing investors is how best to cope with this volatility. If your investment horizon is six months, there are simply too many large drawdowns for this approach to be sensible or viable. Valuation alone cannot deliver the brief, but the alternative is daunting. We suspect it s no trivial undertaking to attempt to anticipate every shift in sentiment in order to limit the downside without conceding the upside. An alternative approach is to take a longer term view, adjust your sights from a rapidly moving target to one moving at a slower pace. If we take the same data series, but adjust it for the average holding period at the inception of the series in 197 five years the picture is transformed (Figure 5). Figure 5: MSCI World Value Index minus MSCI World Growth Index 5-Year Rolling Returns (%) 1-1 - - Jun 1981 MSCI World Value Outperformed Growth MSCI World Growth Outperformed Value 1989 1997 5 Apr 1 Source: SSgA & MSCI, as of 1 May 1 Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. On a longer term view it would seem that the outcome is more predictable, and the Value / Growth premium is there for all to see. More importantly, longer holding periods invite the power of compounding to the party. While the MSCI World Value Index has outperformed the MSCI World Growth Index by just above % per annum since their inception in 197, the total return to Value, at approximately %, is double that of Growth. Nevertheless, as can be seen, value still experiences periods when it remains stubbornly out of favour. At the peak of the dot com boom, value as a factor was widely disregarded. It seemed as if there was no price considered too high for exposure to the growth that would inevitably be driven by one of the greatest innovations the world had ever seen. We know now, of course, how that played out. The interesting aspect to this is that these
investors were correct in their analysis. The internet and related technologies did change the world, possibly to an even greater degree than anticipated. But that turned out to be of scant consolation to those who paid too high a price for that exposure. The period since the Financial Crisis has also been noteworthy in that again we find value out of favour. Since 7, value has had short periods of relief, but on the whole it has faced quite a headwind. Once again, valuation, or price, seems to have been demoted as a measure of the attractiveness of an investment opportunity. Following the Value Trail However, the subset of the market that seems to offer value of late is radically different to what we have found in the past. Whereas for most of the last twenty years our opportunity set has typically been made up of companies that offer stable, defensive growth, today our search for cheap stocks has led us to a segment of the market that is in many ways new territory for us high beta, volatile, cyclical stocks. As a team we have found this somewhat unsettling. For some time now our screening tools have relentlessly challenged us to work on companies that have usually been out of our price range. Our stocks meetings have been dominated by the types of cyclical, economically sensitive companies that have typically been the preserve of growth investors. As one of our colleagues remarked, value stocks just don t seem to be cheap any more, referring of course to those stocks that we had become accustomed to holding in the past. As a consequence of the opportunities that our stock research uncovered, the beta and volatility of our strategies rose over this period. We began to interrogate ourselves to ensure that we had not drifted away from our long-standing approach to stock selection, that we were not assuming undue risk, and that we had not, heaven forbid, allowed optimism of any sort to creep into our thinking. The chart in Figure illustrates, in a very simple way, the regime change we have seen in equity markets since the onset of the financial crisis. We mapped the MSCI World Index by beta, divided it into quintiles, and then tracked the Price/Book ratio of the top and bottom quintiles over the last twenty years. Figure highlights several trends that we find interesting: Figure : Median P/B Highest and Lowest Beta Quintiles Median P/B Dec 1991 Q1 (Lowest Beta) Q5 (Highest Beta) 199 1997 9 Dec 1 Source: SSgA & MSCI as of 1 December 1 Past performance is not a guarentee of future results. High beta stocks have typically traded at a premium to low beta stocks. The valuation spread between the two groups of stocks is unusually wide. It s not unreasonable to point out that these high beta names may be cheap for a reason, and that is a point that we are willing to concede. But we would argue that cheap stocks are always cheap for a reason, and as long term value investors we want to buy them when they are cheap and own them over the period when those reasons go away. The challenge therefore is to determine whether the reason du jour is permanent or temporary in nature. We understand why, with all the uncertainty out there, market participants might be drawn to less-risky areas low volatility, high dividend yield, even short-dated sovereign bonds but as value investors, we are only interested if these securities can be acquired for less than they are worth. It remains to be seen, but overpaying for safety on the grounds that economic headwinds are today s new normal strikes us as a strategy likely to deliver similar outcomes to overpaying for growth when economic tailwinds were considered the new normal. The cornerstone of our approach centers on our belief that the key risk we face as investors is paying the wrong price for an asset. It is not the exposure one assumes that determines the outcome of an investment decision, but rather the price that one pays for that exposure. Low beta stocks have rarely been more expensive on Price/Book ratios. High beta stocks have seldom been cheaper on the same metric. cheap stocks are always cheap for a reason, and as long term value investors we want to buy them when they are cheap and own them over the period when those reasons go away.
Over recent years SSgA Fundamental Equity portfolios have developed a bias towards volatile shares of economically sensitive companies; not because we have an optimistic view of the world, but because they are cheap. Paying a premium for an asset requires a high degree of certainty in a particular outcome. As Voltaire observed: Doubt is not a pleasant condition, but certainty is absurd. Our research and investment discussions always begin with an acceptance that the future is invariably uncertain, and focus on the degree to which the price we are paying for an individual security adequately compensates us to assume that uncertainty. 1 Source: Professor Kenneth French, Tuck School of Business; Website; value/growth premium US equities, 19 1. Source: Dimson, Marsh & Staunton, Value/Growth Premium, World Index, Various dates, longest from 1975 1, Credit Suisse Global Investment Returns Yearbook, 11. MSCI, Factset as at 1 May 1. Pluck of the Irish. (March 1) Institutional Investor. http://www.institutionalinvestor.com/article/181/search/pluck-of-the-irish.html We go where the value takes us. While that may have brought us to a different place compared to five years ago, that is simply the outcome of a consistent long standing approach to investing in equities. The portfolio characteristics that we have become familiar with over time no longer seem available in today s markets and our portfolios must reflect that if we are to remain true to our objective. We simply buy stocks we deem to be trading at a discount to their long-term intrinsic value. That is our margin of safety and that is the best risk control we know. SSgA Global Entities Australia: State Street Global Advisors, Australia, Limited (ABN 91 5) is the holder of an Australian Financial Services Licence (AFSL Number 87). Registered office: Level 17, George Street, Sydney, NSW, Australia Telephone: +1 9-7 Facsimile: +1 9-711. Belgium: State Street Global Advisors Belgium, Office Park Nysdam, 9 Avenue Reine Astrid, B-11 La Hulpe, Belgium. Telephone: Facsimile: 7 77. Belgium is a branch of State Street Global Advisors Limited. Canada: State Street Global Advisors, Ltd., 77 Sherbrooke Street West Suite 1, Montreal, Quebec HA 1G1 Canada and Adelaide Street East, Suite 5, Toronto, Ontario, M5C G Canada. Dubai: State Street Bank and Trust Company (Representative Office), Suite th Floor, Building, Emaar Square, Dubai, United Arab Emirates. Telephone: +971 ()-78 Facsimile: +971 ()-7818. France: State Street Global Advisors France. Authorised and regulated by the Autorité des Marchés Financiers. Registered with the Register of Commerce and Companies of Nanterre under the number 1 5 8. Registered office: Immeuble Défense Plaza, -5 rue Delarivière-Lefoullon, 9 Paris La Défense Cedex, France. Telephone: (+) 1 5 Facsimile: (+) 1 5 1 9. Germany: State Street Global Advisors GmbH, Brienner Strasse 59, D-8 Munich. Telephone +9 ()89-55878- Facsimile +9 ()89-55878-. Hong Kong: State Street Global Advisors Asia Limited, 8/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong Telephone: +85 1-88 Facsimile: +85 1-. Ireland: State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin. Registered number 151. Member of the Irish Association of Investment Managers. Italy: State Street Global Advisors Ltd., Sede Secondaria di Milano - Via dei Bossi, 11 Milan, Italy. Telephone: +9 1 Facsimile: +9 155. Japan: State Street Global Advisors, Japan, 9-7-1 Akasaka, Minato-ku, Tokyo Telephone +81 5 78. Financial Instruments Business Operator, Kanto Local Financial Bureau (Kinsho #5). Japan Securities Investment Advisers Association, Investment Trust Association, Japan Securities Dealers Association. Netherlands: State Street Global Advisors Netherlands, Adam Smith Building, Thomas Malthusstraat 1-, 1 JR Amsterdam, Netherlands. Telephone: 1 785 Facsimile 1 7851, SSgA Netherlands is a branch of State Street Global Advisors Limited. Singapore: State Street Global Advisors Singapore Limited, 18, Robinson Road, #-1 Capital Tower, Singapore 891 (Company Reg. No: 719D), Telephone: +5 8-75 Facsimile: +5 8-751. Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-87 Zurich. Telephone +1 () 5 7 Facsimile +1 () 5 7 1. United Kingdom: State Street Global Advisors Limited. Authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 5998. VAT No. 577591 81. Registered office: Churchill Place, Canary Wharf, London, E1 5HJ. Telephone: 95 Facsimile: 95 5. United States: State Street Global Advisors, One Lincoln Street, Boston, MA 111-9. Web: www.ssga.com The views expressed in this material are the views of Barry Glavin and Brian Routledge through the period ended May 1, 1 and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Investing involves risk including the risk of loss of principal. Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries. The MSCI is a trademark of MSCI Inc. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. 1 State Street Corporation. All Rights Reserved. ID819-INST-98 1 Exp. Date: //1 5