by Peter Brooke, Head of Quantitative Investments, Platypus Asset Management
Against subdued inflation and wages growth, global growth, supported by policy, surprised to the upside in 2017 and equity markets performed strongly over the year. Despite the recent market volatility, we remain constructive on the outlook for equities in 2018. Careful portfolio positioning remains paramount.
A factor portfolio is constructed from a group of stocks, all of which have similar characteristics. For example, a factor portfolio based on value might be constructed from the cheapest 20% of stocks in the ASX 300. Over long periods of time, some factor portfolios perform better than both the index and the average active fund manager. The extent to which the excess returns generated by an active manager can be replicated using factors, at the very least, raises the bar for active management. This is partly responsible for the trend towards using factors to construct portfolios.
Broadly, fund manager strategies can be considered growth, value or style neutral. Growth managers are happy to pay price-to-earnings multiples that are often higher than average for earnings growth, value managers prefer stocks that are cheaper but whose future prospects carry higher uncertainty, and style neutral managers combine the two. Different styles outperform at different times of the investment cycle. It follows then that if an equity investor estimates accurately which styles will be in favour, overall returns may be significantly improved. Given recent returns to equities, and the present stage of the economic cycle, the question is whether value will outperform growth over the coming months and years.
Before presenting our view on value versus growth in Australian equities, we think that timing factors are difficult. For example, moving from value to growth and back again incurs transaction costs at a portfolio level. Also, over long periods it is hard to time the rotation such that it adds value every time. For this reason, we tend to favour a portfolio that has both value and growth characteristics, with the final composition determined by prevailing local market conditions.
In Australian equities, different factors have performed differently over time. Since 1992, $1 invested in the cheapest stocks (as measured by price to book) became $2.07 by November 2017. Compared with return-on-equity ($11.33) or the index as whole ($10.17) this is disappointing.
Chart 1 (Source: Platypus): Cumulative returns to $1 invested in four factor portfolios compared to the index. The portfolios are constructed from the top 20% of stocks as ranked by the metric shown in the label.
We use price-to-book value to look at the performance of value compared to growth through the cycle. The value portfolio is constructed from the cheapest 20% of stocks in the S&P ASX 300 as measured by price-to-book, and the growth portfolio from the most expensive 20%.
Chart 2 (Source: Platypus, IRESS, Factset): Outperformance of growth compared to value using the S&P ASX 300 index. Growth outperforms value by an average of 3.98%
Observing the chart, there are two periods where value outperforms growth in a substantial way, and one where growth outperforms value. Over 24 years, the average outperformance of growth compared to value is 3.98% on a twelve month rolling basis. This is an important fact to note. Australian equity investors should be cognisant of this performance if they intend to aggressively use value in their portfolios. Factor performance is different. Depending on the equity market, differences over many decades can be substantial.
We look at the two periods when value outperforms strongly.
The first period was during the global financial crisis (GFC). The equity market lost nearly 50% of its market capitalisation over a period of 15 months. During this drawdown, companies with stable earnings and higher price-to-book value outperformed the broader market. This was evident in sector performance: Health Care returned -17.7% over this period, while Industrials returned -56.2%. Stocks that had lost the most and were still solvent, then rebounded the strongest, leading to value performing better than growth from the low in March 2009 to the beginning of 2010. The rally was sharp and fast, and occurred during a period of extreme volatility both in capital markets and economies around the world. It was an event that happens rarely, and is unlikely to be repeated in the short term. Therefore when value materially underperforms (as it did leading into March 2009), the likelihood of extreme outperformance may be subsequently higher. This is not the case at present.
The second period where value outperformed, although less strongly than during the GFC, was in the fourth quarter of 2016. The economic conditions were different to the GFC: the unemployment rate was declining, GDP growth was at long term averages, interest rates were supportive, and equity market volatility was relatively low. There was no obvious signature prior to the sharp outperformance that could have been derived from the previous value rally in the GFC. On a twelve month rolling basis, growth had outperformed value for 2 years, which in normal market conditions is a long time compared to history. Growth outperformed during the Technology-Media-Telecoms rally in the late 1990s for 36 months and in 2007 to 2009 for 29 months. In addition, the portfolios were not trading at valuation extremes. Simply put, growth had outperformed value for a long period, and was beginning to underperform, returning to long term averages.
During the Technology-Media-Telecoms rally in the late 1990s, growth substantially outperformed value. Equities experienced a bull market, driven by euphoria around future technologies, which in its later stages was not supported by traditional valuation metrics. Before investor attitude changed, the most profitable strategy was to buy and hold the most expensive stocks in the sector, leading to value drastically underperforming. Interestingly, removing this period from the data reduces the average outperformance of growth to 0.09% since 1993.
It is difficult to predict extreme moves in growth or value. It seems at the moment that the recent strong run in growth will either continue or base out – it would be unusual for value to perform vastly better than growth from here. From the perspective of Australian equities, a few things are worth noting:
Similar to timing markets, timing factors is difficult. Most importantly, investors should be aware of which factors work best in which markets, and construct their portfolios accordingly. For the Australian investor, the portfolio weight ascribed to growth should at least be on par with that ascribed to value.
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