Executive summary
- A year ago, the contrarian value investor seemed on the brink of extinction. The situation appears to be reversing and we are now seeing tailwinds for value assets over a medium-term investment horizon.
- The mega cap era between 2010 and 2020 driven largely by QE gave rise to extreme herding behaviour and a record high divergence between growth and value assets.
- Despite feeling quite dramatic, the recent reversal is hardly visible from a longer perspective, indicating massive potential for a continued value rotation in global equity markets.
- The huge flows into passive vehicles at the expense of actively managed funds have reduced market efficiency and created opportunities for active value investors with a longer time horizon. We are now starting to see the results directly derived from these opportunities or market inefficiencies.
- Growth stocks in general – and mega-cap technology companies in particular – are facing headwinds. Anti-trust regulations to tackle the tech behemoths are increasing, not only in the US, but on a global basis.
- As the capital flows turn, and index-mimicking mandates start to underperform, we believe the market will become more balanced and the current biases in global equity markets will be removed.
- SKAGEN Focus is one of the few remaining mutual funds investing in micro, small and mid-cap companies with a contrarian and value-based approach. We have stuck to our investment philosophy and this discipline is now delivering strong returns for our unitholders – the fund has generated a return of 91.8% over the past 12 months versus 36.4% for the benchmark index in the same period[i].
Conclusion: As valuations start to matter again, there is still significant potential for a continued rotation from excessively priced growth stocks into attractively priced value stocks. We should see a more balanced investment approach between what has worked over the last decade versus what has worked over the last century.
Is value investing back from the wilderness?
Around twelve months ago we wrote about how traditional value investing – buying unpopular assets that are substantially undervalued relative to an estimate of fair value – could return to favour. Few market participants thought this was a likely scenario and the contrarian investment style was facing the threat of extinction. We also highlighted that if you wanted to invest in a global, deeper value fund with a focus on micro, small and mid-cap companies, you would be hard pressed to find one!
This is probably still the case, although over the past six months we have observed several tailwinds for value assets in general and distinct headwinds for growth stocks, particularly large/mega cap technology companies, which still dominate index baskets across global equity markets.
In this article, we re-examine the factors we described a year ago and discuss the potential for these forces to create further tailwinds for value assets over a medium-term investment horizon.
Value investing the contrarian way
The goal of SKAGEN Focus is to find substantially undervalued equities versus our estimate of fair value with tangible catalysts for revaluation over a two to three-year period. We find it strange that most investors are interested in buying almost anything at a discount except stocks. This has been the overriding theme in global equity markets over the past few years, and ever since central banks introduced quantitative easing (QE).
While the market is efficient in some respects, its efficiency has decreased substantially over the past few years with the massive flows into passive instruments. This trend, exacerbated by the rise of algorithmic trading and momentum-based strategies, has challenged value investing. The tide now appears to be turning with the comeback of price driven investments and the re-emergence of the price discovery mechanism across global equity markets.
We believe that to be able to deliver competitive returns over time we need to swim against the tide. Our investment approach has and will inevitably generate returns that deviate significantly from the underlying global equity market. Being contrarian in our view means being reasonably skilled at identifying several different market phenomena. We are not satisfied with only finding cheap assets, they must also be misunderstood and undervalued for the right reason.
Temporary market dislocations and unwarranted perceptions create opportunities for contrarian investors. Reduced analyst coverage of small and mid-cap stocks provides further possibilities to find equities that are overly cheap. Catalysts are also required to re-rate a stock from being undervalued to fairly priced. In our valuation framework, these triggers are as crucial as the price and we think hard about how the market will discover it is wrong in its valuation assessment of a specific asset.
As experienced value investors, we have remained true to our investment philosophy. We recognise that fashions come and go in financial markets, and over the last ten years we have seen some of the most extreme collective herding behaviour in global financial market history. Is there reason to believe the winds have finally changed?
There are five factors that indicate this may be the case:
1. Divergence between value and growth assets
The below chart shows the MSCI Global Growth index plotted against the MSCI Global Value index since 1975. The graph sheds light on the extreme starting point for the current rotation into value assets from the over-owned and quite possibly overvalued growth assets in global equity markets. It clearly highlights the "mega cap tech era" between 2010 and 2020, which was largely driven by the rise of QE and the prevalence of the global penguin investor. We still see this herding behaviour, particularly in relation to the largest technology stocks, which signals a clear deterioration in risk/reward for index-heavy portfolios in the mid-term versus actively managed portfolios. Despite feeling quite dramatic, the recent reversal is hardly visible on the chart, indicating massive potential for a continued value rotation in global equity markets.
Chart 1 – World Value vs Growth since 1975 (Source: Goldman Sachs)
2. Capital flows turning
As mentioned above, there have been massive flows into passive vehicles at the expense of actively managed funds, especially value-focused ones. Investment decisions are based solely on size – valuation is not considered – and capital is directed towards the biggest global companies, essentially following a momentum-type trading strategy that makes highly valued stocks even more expensive. They are anti-value in nature and have, at worst, removed the entire price discovery mechanism from global equity markets. We also fear that a passive approach often ignores investors' fiduciary responsibility, for example to engage with companies to improve governance and capital allocation.
We believe that this shift has reduced market efficiency and created huge opportunities for active value investors with a longer time horizon. We are now starting to see the results directly derived from these opportunities or market inefficiencies.
Another observation is that value assets gradually turn into "momentum" stocks. This might seem counterintuitive but was the case between 2001-2007 which was an interesting period for value assets in broad terms. We will not speculate on the potential for massive capital flows to chase value stocks via the ETFs, machine and quant investing models that drive the world's equity markets, but if this environment should occur, there are likely to be interesting opportunities for value investors like ourselves to start looking at a more attractively priced technology segment.
3. The ultra-low interest rate environment
The ultra-low interest rate environment has fuelled the attraction of companies with specific characteristics over the last ten years. The return that investors require to hold long duration assets has collapsed in line with the current interest rate environment. It has also supported the implicit view that these longer-term profits are 'secure', which may be an over-optimistic assumption. Now, the situation seems to have changed and the record monetary and fiscal stimulus poured into economies have created a substantial steepening of the yield curve. Over the last few months, US ten-year bond yields have risen more than 100 basis points, and this is now also affecting global bond markets. Financial markets are trying to accurately price in higher inflation expectations on the back of soaring commodity prices and record stimulus. The rise in long-term interest rates will eventually become a parallel shift in the curve.
Chart 2 – Global yield curves - steeper or much steeper? (Source: Exane BNP Paribas)
The positive impact on value is two-fold. First, traditional financial companies, such as banks and insurance companies which have been ignored for a decade, will come back to life as spread income increases. Second, bond proxies, such as mega-cap technology companies, will see their lofty multiples deteriorate as the discount rate moves higher. Investors will essentially be willing to pay more for the front end of the earnings curve than further out along the curve.
4. The rise (and potential fall) of “Super Big-Tech” companies
This phenomenon gave rise to a binary world in which certain industries have been regarded as uninvestable. It also ignored shorter term cash flows and the value of tangible assets while the value of intangible assets may have been overestimated by market participants.
Now growth stocks in general – and mega-cap technology companies in particular – are facing headwinds, which alter the situation. Anti-trust regulations to tackle the tech behemoths are increasing, not only in the US, but on a global basis. Their business models and corporate governance are being questioned as these companies not only prohibit fair and necessary competition, but also collect personal data without people's awareness. They have grown massively and the simple "law of large numbers" is making it difficult to maintain the high growth rates. Huge cash flows have been allocated to different projects with a very uncertain return for shareholders. As growth rates fade and competition sets in, these companies will be exposed as being fairly cyclical assets often reliant on advertising revenues.
5. The herding factor - the eventual decline of the penguin investor
Over the last 10 years we have seen one of the most extreme examples of herding and concentration risks in global equity markets. The pool of money chasing value assets has shrunk continuously. The fear of career risk and reassurance of being invested in the same companies as your peers run deep within the asset management industry. As the capital flows turn, and index-mimicking mandates start to underperform, we believe the market will become more balanced and the current biases in global equity markets will be removed.
SKAGEN Focus – a value-based fund with a focus on small and mid-cap companies
We believe that SKAGEN Focus is one of the few remaining mutual funds investing in micro, small and mid-cap companies with a contrarian and value-based approach. We take pride in having consistently applied our investment philosophy and process, and not having bowed to the fashions of the day. This discipline is now delivering strong returns for our unitholders. Since COVID-19 sent shockwaves through global equity markets twelve months ago, SKAGEN Focus has returned 91.8% as measured in euro versus the underlying benchmark of 36.4% (MSCI ACWI) and the global value index (MSCI ACWI Value) of 43.2%[ii].
Conclusion
We believe global equity investors have experienced a decade of extreme polarisation. If we are correct, there is still significant potential for a continued rotation from excessively priced "low-volatility growth stocks" into attractively priced value stocks with strong near-term cash flows and tangible assets. Valuations matter again. An intriguing cocktail of a steepening yield curve in response to higher inflation expectations, maturing growth rates in globally disruptive mega-cap companies, a rotation in capital flows, thawing trade tensions, monetary and fiscal stimulus, and increased M&A activity could propel the rotation. At the very least, it points to a more balanced investment approach between what has worked over the last decade versus what has worked over the last century.
Footnotes
[i] As measured in euro for the period 13 March 2020-31 March 2021, source: Bloomberg. Over a five-year period up to 31 March 2021, the fund has returned an average annual return of 11.2% versus 12.5% for the benchmark in the same period.
[ii] As measured in euro for the period 13 March 2020-31 March 2021, source: Bloomberg. Over a five-year period up to 31 March 2021, the fund has returned an average annual return of 11.2% versus 12.5% for the benchmark in the same period.