10 Jun 2020
1 June 2020 | James Clunie, Head of Strategy, Absolute Return | Ivan Kralj, Assistant Fund Manager, Absolute Return
At the heart of our investment philosophy sits a very simple belief: the price you pay for an asset matters.
When we buy a share in a firm, we receive the right to participate in a share of future cash flows generated by that business. The price one pays today ultimately must matter for the expected return on that asset.
As a result of having this belief, we incorporate a ‘valuation analysis’ into our investment process. Along with quantitative analysis, the reading of financial statements and examining the share register, we undertake a reverse discounted cash flow analysis (‘reverse DCF’). Using a reverse DCF leads us to long positions in stocks where expectations are conservative or sensible; and to short positions in stocks where expectations are aggressive, even heroic at times.
On most measures, the current performance gap between value and growth rivals other historical extremes; the environment for value investors has remained enormously challenging and is akin to the similar periods around the Great Depression and the dotcom bubble. Even as the Covid-19 pandemic hit global stock markets, rather than narrowing the valuation spread, the most highly-rated stocks sold off less sharply (on average) than the lowest-rated stocks, and they have subsequently rebounded more quickly.
So, what caused this gap to widen even further when global stock markets slumped? While it is difficult to pinpoint one reason, we believe it was at least partially due to forced sales by value managers who were suffering redemptions after several years of underperformance. As some value managers were forced to sell already very cheap stocks, valuations were pushed down further; at the same time, several ‘glamour’ growth stocks have remained very popular, despite weak fundamentals in many cases, following strong and sometimes spectacular performance. Beyond this, there are surely sector mix effects (think cloud computing vs oil stocks), sentiment and idiosyncratic factors.
Interestingly, a recent paper by AQR finds that today’s extreme performance gap is more down to ‘many diversified, discounted cheap stocks’ rather than ‘a few super-expensive global winner firms’, though both factors do go some way to explaining this gap. In fact, it finds that, ‘even if we never allowed trading in the largest 5% of stocks (the megacaps) or all the tech, telecom and media stocks, or even the 10% most expensive stocks on a P/B measure, something that eliminates the stocks today most often discussed as a problem for the value strategy, today’s valuation spread would still compare exceptionally favorably to history.’1
While it’s not possible to predict what will happen over the coming years, historically, when value has underperformed this significantly, the subsequent nominal and real returns have been very attractive. We believe there are already several potential catalysts that could change the ‘growth vs value’ dynamic, and we think it’s an interesting time for investors to ask whether they want to invest in growth or value from here.
Figure 1 Value has always had periods of underperformance
Annualised returns of Value vs. Growth rolling five-year basis (1926-2019)
US data series. Source: Calculated based on data from Kenneth French’s website (mba.tuck.Dartmouth.edu/pages/faculty/ken.French/index.html), which was. derived from the CRSP (Centre for Research in Security Prices) COMPUSTAT merged database. Total return of lowest valued tercile vs highest value tercile. Dataset from 01.07.26 to 28.02.20.
Figure 2 More extreme than dot.com bubble
MSCI World Valuation Dispersion
Source: Bernstein Research. Relative P/B Ratio between Most vs Least Expensive Quintiles Equally Weighted, Dec 1974 - Mar 2020
We are primarily bottom-up stock pickers, incorporating analysis of market ecology, quantitative signals and fundamental analysis. This process leads us to buy stocks that appear cheap, which are robust and of a decent quality. In terms of the short book, we try to identify stocks that appear expensive, with some sort of fragility or weakness, such as EPS downgrades. We also closely monitor the top-down risks that we are taking as a result of our stock-picking, and we look to hedge out some of these risks.
The fundamental analysis component of our process is formed of two key components: a reverse DCF with sensitivity analysis, and the reading of quarterly statements and annual reports. This process results in a portfolio where we are long ‘value’ stocks – primarily in countries like the UK, Russia and Japan today – and short ‘not value’ or growth stocks, primarily in the US.
Figure 3 Fundamental analysis
Valuation tool: reverse DCF
Any stock examples are used for illustrative purposes only and should not be viewed as investment advice.
Source: Willis Welby LLP, as at 29.02.20
Figure 3 demonstrates our use of reverse DCF calculations to identify potential stocks for the strategy’s long and short books. The first example is BAE Systems, which is held in the long book. It’s an ‘out of favour’ UK stock that looks particularly cheap on a reverse DCF basis. It offers an attractive dividend yield and trades at a significant discount to some of its competitors, particularly those in the US.
In contrast, the second chart shows the reverse DCF for Intuitive Surgical, which is held in the short book. The company specialises in robotic-assisted surgery. In April, it warned it has been experiencing a significant decline in procedure volumes, as elective medical procedures are being postponed. Hospitals around the globe are deferring purchases of equipment as they grapple with the pandemic, and this is significantly impacting operations and financial results at medical equipment providers. The shares look very expensive on a reverse DCF basis, and they rose further following April’s announcement. We believe the market might be too complacent and is underestimating how much the current trends could affect this business over the longer term. The stock currently trades at more than 40x last years’ adjusted earnings.
Figure 4 Characteristics
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| Source: Factset | ||||
Figure 4 further highlights the stark contrast between characteristics of stocks held in the strategy’s long and short books. For example, while the average price/earnings ratio of the long book is 10.9x, it is 23.6x for the short book. Stocks held in the long book also offer a far higher average dividend yield, at 5.5%, compared to just 1.6% for those in the short book. As a result of our fundamental-driven process, the fund should therefore be well positioned to benefit from a sustained rotation from growth into value.
It is inaccurate to assume that (sensible) growth investors ignore valuations entirely – both value and growth investors do care about valuation. Instead, the difference lies in where they believe they can find greater payoff. Aswath Damodaran explains this difference well: ‘Value investors believe that it is assets in place that markets get wrong, and that their best opportunities for finding "under-valued" stocks is in mature companies with mispriced assets in place. Growth investors, on the other hand, assert that they are more likely to find mispricing in high growth companies, where the market is either missing or misestimating key elements of growth.”
Our scepticism in one’s ability to forecast future events is therefore one of the reasons why we gravitate towards value investing – we remain convinced that the best opportunities can be found in undervalued stocks of mature companies that already have significant assets in place, but which we believe are being mispriced.
Indeed, long-term studies show this is a good way to invest and that our process is a sensible way to analyse the worth of assets. While the consistent outperformance of growth vs value has been particularly difficult for the Jupiter Absolute Return Fund over the past few years, from such an extreme starting point relative to growth, we believe the outlook for value stocks relative to ‘not value’ stocks looks particularly encouraging.
So, what will cause value stocks to outperform growth stocks? And when could this rotation happen? Our best answer is that from such extreme levels as we see now, it could happen at any moment. Normally one would expect a clear catalyst, like a recovery in economic growth, or a reflationary impulse. Perhaps these will come in the form of a recovery from lockdown, or a fiscal stimulus splurge – indeed, some of these catalysts could already be in place. Alternatively, a rotation could happen for no obvious reason as some investors switch preferences, or as a need for investor liquidity arises.
Although some commentators suggest that this stock market swoon looks like 1987’s rapid crash and recovery, we think it differs because there is a clear catalyst for the market selloff this time, and a clear real-world impact. To us, the current environment feels most similar to 2000, which saw a growth stock/‘TMT’ bubble and the elimination of several well-reputed investors just before the turn. Even though the market finally started to fall in March 2000, large-cap growth stocks kept climbing until Intel’s profit warning in autumn 2000, and then the rotation from growth to value really got underway. The US Federal Reserve was actively cutting interest rates to try to prevent a recession at the time. As growth stocks fell, the accounting frauds were gradually revealed to the market, including Enron and Worldcom. So, the catalyst then was an iconic growth stock disappointing the market six months after the market turned, then some critical analysis of firms’ cash flows and accounts.
Towards the end of 2019 we did start to see some signs of changing market behaviours that suggested the market regime could be coming to an end. The failure of the WeWork IPO, for example, made investors start to think about the price they pay for high sales growth, capital-hungry, loss-making stocks. The stock was initially touted with the usual fanfare: stories about the brilliance of the company’s business model and genius of its founders, which eclipsed questions about a gaping lack of profitability. When the planned IPO-price was halved and halved again, and the IPO ultimately pulled, it seemed that investors’ sensibilities had begun to change. However, WeWork’s failure has not been a sufficient catalyst to change the general market pricing of firms with rapid growth, low profitability and often weak balance sheets. For now, we will have to wait and see how this mega-cycle plays out – it could be dissimilar to previous periods of value underperformance, or it might just rhyme.
1 Source: AQR
Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested.
Risks
The fund uses derivatives, which may increase volatility; the fund’s performance is unlikely to track the performance of broader markets. Losses on short positions may be unlimited. Counterparty risk may cause losses to the Fund. This fund invests in securities issued or guaranteed by the United Kingdom which may exceed 35% of its value. The Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request.
Important Information: This content is intended for investment professionals and is not for the use or benefit of other persons, including retail investors. It is for informational purposes only and is not investment advice. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. Past performance is no guide to the future. The views expressed are those of the Fund Manager(s) at the time of writing, are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given. Holding examples are not a recommendation to buy or sell. Quoted yields are not guaranteed and may change in the future. Issued by Jupiter Unit Trust Managers Limited (JUTM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ which is authorised and regulated by the Financial Conduct Authority. No part of this content may be reproduced in any manner without the prior permission of JUTM. 25667
