Following a strong year for equity value strategies in 2016, the erosion of that outperformance through the first half of 2017 has left value returns much on a par with growth stocks for the past 18 months. That period of value outperformance was brief in a historic context, and particularly so when viewed against a decade of value underperformance. As value investors, we naturally find this unsatisfying, but accept that market patterns rarely play out exactly as they did before.
Valuation dispersions remain quite high across styles, sectors and regions. Global capitalisation-weighted equity indices do not appear particularly cheap, but valuation anomalies that benchmark-agnostic investors can exploit continue to exist. One such anomaly is the large US weighting in global indices — now 10 percentage points higher since 2010.
The higher weight of an increasingly expensive asset makes life difficult for benchmark-aware investors and serves to reinforce our preference for bottom-up portfolio construction.
US stocks expensive
The US market is expensive against both its own recent history and in a global context (see figure below). Investor optimism about corporate profits or tax and regulatory relief likely plays a part. The makeup of the index itself is also a likely factor, with one particular group of large growth companies seemingly exempt from valuation norms.
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Facebook, Apple, Amazon, Netflix and Alphabet (Google) — the so called 'FAANG' companies — account for approximately 10% of the S&P 500, but have contributed about 25% of the index gain in 2017. These stocks also screen amongst the least volatile in the market.
Rising share prices and low volatility tick the boxes for algorithmic investors who have been drawn to these stocks. And as Bank of America noted: “Rarely ones to shun the herd, active funds are now 71% overweight in the FANG companies after making the biggest move from value to growth since 2008.”1
In State Street Global Advisors' Fundamental Value Equity Team, we are just wired a little differently. In the prevailing US market environment, we have observed that some of the biggest detractors from the relative performance of our US equity strategy in 2017 have actually been stocks we do not hold. Many of those non-holdings are found among the FAANGs (and their various derivatives). In the context of the concentrated strategies that we manage, this is quite an unusual occurrence.
Perhaps a new paradigm of corporate profitability has evolved — a winner-takes-all scenario dominated by platform monopolies. But history is littered with ‘new paradigms’:
- Japan had 13 of the top 25 global companies in 1989. Today, it has none.
- Technology stocks that survived after 2000 took years to justify a fraction of their peak valuations, despite the success of the technologies those valuations were built upon.
- Few financial stocks from 2006/2007 maintained their lofty positions.
What we do know is that US — and by extension global — equity indices are being driven by relatively few very large companies that require unprecedented profits to maintain their leadership.
European renaissance
The increased weight of US equities in global indices has also been facilitated by Europe’s travails since 2008. In the post-financial crisis climate that saw insolvencies at a national level, political upheaval, high unemployment and terrorist attacks, it’s no wonder investors shunned European stocks — even as their discount to US stocks increased. European equities also experienced greater volatility, creating another valuation anomaly, given the fixation of many investors on minimising volatility.
During this period — when our global equity strategies reflected overweight Europe/underweight US positions — many European companies have restructured, cut costs and deleveraged, aided by euro weakness. As economic activity has since recovered, positive earnings revisions in Europe are now among the strongest in the world. The combination of depressed valuations and cyclically depressed earnings is a powerful draw for bottom-up value investors, and we have reaped significant excess returns as our expectations for future earnings power have started to play out.
In 2017, for the first time in many years, European equities are outperforming those in the US. Not everything is cheap in Europe. Notwithstanding the fact that they offer highly sought-after traits (stable earnings and low volatility), consumer staples are simply expensive. Staples used to be a fertile hunting ground for value investors but their high valuations remind us that value does not remain fixed. We go where the value takes us.
Asian opportunities
On many levels, Asia-Pacific markets are the antithesis of Western markets. Asian markets are cheap in absolute terms; at 1.50x, the price/book ratio of the MSCI Asia Pacific Index has rarely been lower.
However, earnings power in some Asian segments has eroded significantly, necessitating significant bottom-up research endeavour to unearth value, including rigorous assessment of governance and balance-sheet management. Diverging from themes elsewhere, Asian consumer sectors currently present more compelling fundamental value characteristics.
Earnings power had been inflated by excessive fixed asset growth in China, and capital-intensive sectors such as construction, chemicals and steel now appear to be suffering from structural over-capacity. These entities, many with significant state ownership and high debt, pose a potential risk to attempts by authorities to restructure the economy.
A regional growth scare had led to a de-rating in adjacent sectors such as financials, consumer and industrials — we believe these areas offer a potentially rich seam of value for stock-pickers.
We are also finding value in Japan, particularly within the financials and industrials sectors. We have done a lot of work around governance, and our balance sheet-focused investment framework is well-equipped to look at the potential for improving capital efficiency.
Brian Routledge is Head of Portfolio Management, Fundamental Equities, at State Street Global Advisors. To learn more about how our active fundamental value strategies can help your portfolio, please visit our website.
1 Bank of America, May 2017.
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