In 2020, just before the pandemic shook global equity markets, we identified how unpopular value stocks could rediscover their unconventional success, leading to the return of a financial environment where traditional equity valuation metrics would once again be relevant. We compared the investment environment at the time with the emergence of the group of stocks dubbed "Nifty Fifty" in the early 1970s and identified a subset of global equites with highly elevated valuation multiple, the "reborn Nifty Fifty". We wrote about the five major foes of value investing and five emerging catalysts for change.
The investment environment today is clearly very different from the financial world we faced in early 2020. Here we take a brief walk-through history to help understand how things have changed and why it is now undeniable that valuation matters.
2010 - 2020: QE and the Tech Behemoths
This was the era of Quantitative Easing (QE) following the financial crisis, and the emergence and advancement of the gigantic US and Asian technology monopolies. It is striking that these two anomalies occurred during the same period, which is probably a rarity in financial history. The availability of easy money and unrealistic growth assumptions fuelled a boom in valuations which proved to be unsustainable. As was the case with the IT bubble in 2000-2001, "new" valuation multiples were driven by promoters of speculative and overvalued equities, for example relative market cap-to-sales ratios became the norm and are still being used as ammunition to defend overvalued companies. We believe financial markets are still in the process of sobering up from this irrational environment, as valuations still look very lofty in certain areas of equity markets.
2020 - 2021: The Pandemic Puzzle
The pandemic in early 2020 shattered the financial puzzle in just a matter of months and important pieces have not fallen back into place. The global economy came to an almost complete standstill in February 2020 and was only gradually restarted in late 2020. The initial reaction in global equity markets was markedly negative. Industries laid off skilled workers, which has now led to a major labour shortage in many industries. Supply chain bottlenecks appeared and have still not been resolved. Suddenly, there was a shortage of almost everything - except of course easy money. The pandemic prompted another round of extreme global financial stimulus from central banks. The foundation for inflation to enter the economic landscape was cemented. Market participants seemed to ignore this and global equity markets not only recovered quickly but reached stunning new highs in late 2021.
2022 - present: The New Cold War and QT
Without Russia's disastrous decision to invade Ukraine, the inflation picture would probably have been quite different. The invasion created numerous inflationary tailwinds, primarily in global commodities. Russia and its surrounding neighbours are substantial producers of wheat, gold, nickel, palladium, potash, groceries and of course oil and gas. Moreover, the areas are important sub-suppliers to several industries, including the auto industry. The market's reaction was swift and brutal; commodities, energy and food prices spiked in the early days of the invasion. This commodity spike is now being passed on to consumers in value chains across the globe.
The interesting dynamic at play is that the inflationary pressure is, to a large extent, supply rather than demand driven. Are rate hikes the right tool to combat this type of inflationary situation? Global central banks, led by the Federal Reserve, certainly seem to believe so as they are implementing Quantitative Tightening (QT) around the world and aggressively raising short-term interest rates. Japan is so far the possible exception and has refused to end QE, driving down the yen as a result. This situation is now attracting speculators to bet against the Bank of Japan and could potentially force the country to abandon the yield curve control. To us, there is little doubt that the invasion of Ukraine is the start of a new cold war, and an environment reminiscent of the 1960-1980 period. Unfortunately, the conflict is unlikely to be short-lived and could potentially also involve other countries which once were a part of the Soviet Union.
The Five Foes of Value revisited
This brings us to today's investment environment. Global value equities are ahead of their growth equivalent and on track for a second consecutive year of outperformance – probably by their widest margin for well over a decade. What has happened to the five foes of value to make them and are the changes here to stay?
1. The ultra-low interest rate environment drove the investment community's entire focus towards companies with specific characteristics. The multiple expansion in these industries globally soared to record levels at the end of 2021. Since then, we have witnessed a large correction in bond prices in most countries and inflation has climbed above 8 percent in the US and appears to be stickier than anticipated by central banks. The change in the interest rate environment is now forcing investors to focus on higher mid-term earnings yields that can compete with a risk-free bond rate of 3 percent or higher. We are now in the midst of a rotation into stocks with lower valuation multiples at the expense of the elevated areas of the global equity markets.
2. The rise of “Super Big-Tech” companies created a subset of equities where investors manifested "growth-at-any-price" investment behaviour, and the valuation levels of these companies peaked in late 2021. We believe that many of these companies are cyclical at core, as they are dependent on advertising revenues, for instance. This has been painfully visible in the case of several mega-cap tech companies recently, such as social media platforms. Other cyclical elements include retail spending and the normalisation of software budgets across the global economy. The earnings growth in this subset is now disappointing investors and, in some cases, completely disappearing which is causing valuations to nosedive.
3. The massive capital flows into passive investment vehicles are a notable anti-value factor as passive vehicles direct capital flows towards the largest capitalised companies irrespective of valuation of an asset. The underperformance of value over the past decade coincides with the USD 5 trillion rotation from active to passive management[1]. The dominance of passive investments is illustrated in the chart below. However, as the investment environment normalises and the playing field becomes more even, we are starting to see signs of investors returning to actively managed mandates, and specifically those that are value-based. A recent report found that almost 70% of active US mutual funds are outperforming the S&P Index this year[2]. Investors are also discovering that global index mandates are poorly diversified as the concentration risk from major markets such as the US has never been higher.
4. The domination of the penguin investor, fear of career risk and increasing focus on shorter-term investment horizons. We should not underestimate the herding mentality and establishment of investment consensus over the past decade. The rising importance of active management and independent contrarian stock picking has resurrected interest in forgotten value-based investment managers. An investment focus on just a small subset of global equity markets will no longer be sufficient. The herd of penguins are clearly being scattered and confused, generating substantial opportunities for the skilled contrarian active investor.
5. Excessive focus on intangible asset values has been a prevailing argument for elevated multiples in several industries. It is indisputable that intangible assets clearly have some economic value for the likes of software companies or those selling branded consumer goods. Tech companies have ploughed billions of dollars into intangible asset bases where the actual return on these investments is an unknown. The falling multiples of these stocks can be interpreted in many ways, but clearly the market is currently in a de-rating mode when it comes to intangible asset bases, much like the ongoing de-rating of non-profitable companies overall.
Final words
The current investment environment offers lucrative opportunities for active, price-driven and contrarian investors. With equity markets shorn of QE, valuation matters. Our core belief is that to be able to deliver competitive returns over time, investors need to swim against the tide. This will inevitably cause a few sleepless nights, but also substantial return deviations from the underlying global equity market.
For SKAGEN Focus, with our strong value bias and tilt towards smaller companies, the current environment where many sectors are experiencing major drawdowns means our investment universe is expanding and becoming increasingly attractive. The heavy corrections taking place in individual equites is activating our contrarian investment process. We are seeing attractive value propositions starting to form in several industries, such as auto-parts producers, retailers as well as select technology companies.
A Word on Value
Scott McNeely was the CEO of Sun Microsystems, one of the darlings of the IT bubble in 2000/2001. At its peak the stock was valued at 10x revenues. A couple of years later, he offered the following reflection:
"At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?"
There are a wide range of value investment styles out there, and for any investor it is crucial to agree on: what is value? A simple price/earnings ratio fails to consider a company’s balance sheet leverage. A price/book value in isolation might not be useful as it uses accounting asset values and in addition ignores the economic returns on the asset base. We believe it is appropriate to use an equilibrium analysis between the company's Enterprise Value and Replacement Value, with the addition of the Normalised Economic Return generated on these assets.
The Enterprise Value (EV) includes a company's market cap and outstanding debt, including operating leases, options to management and pension liabilities. The Replacement Value (RV) includes company assets in today's currency; a balance sheet in market value terms. It also tells you how much an industry buyer would need to spend to obtain an identical asset base. In addition, we prefer focusing on Normalised Earnings Power, which essentially illustrates a company’s “true” earnings power in its current form. This implies adjustment for one-time items such as restructuring charges or excess reserve charges in financials. For cyclical companies we attempt to estimate the earnings power or profit margin over a cycle, which enables us to invest in depressed cyclical companies, hopefully near the bottom of the cycle. Indeed, the right time to buy a cyclical asset is when earnings are depressed and companies are even loss-making, provided they are in good overall financial health. We apply the same hurdle rate for industrial assets regardless of geography and a higher level for financial assets since they operate with more balance sheet leverage. Importantly, we require at least 50% upside to our fair value estimate in 2-3 years. It is equivalent to a pay-back period of 6 years or a 16% annual return if we are successful in our investment thesis.
As you can imagine, this valuation framework dramatically narrows our investment universe. Interestingly, as markets tend to over-react and display irrational volatility on a regular basis, these pockets of value constantly change. It is our mandate to find and explore these areas to be able to deliver a competitive absolute return to our investors over time.
References
[1] Source: Morningstar
[2] Source: Bloomberg