The «value» investment style endured a miserable year in 2017, but Hans Ulrich Jost believes that we are seeing a return to valuation-based stock picking, he writes in an essay for finews.first.
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During the last ten years, most yield curves were drawn into negative territory and remained there far longer than even the most dovish central banker anticipated. While this scenario appears to be the biggest aberration since the great depression, many market participants clearly believe it is the «new normal,» and will persist forever. But surely it will unravel sooner rather than later?
Between 2000 and 2007, markets transitioned from a major growth bubble to a major value bubble. This time around the shift is likely to be even more pronounced. The market has created some 2 trillion dollars worth of new investment vehicles since 2009 such as ETFs as well as a wide range of other products which are all chasing the exact same sensitivities – the proxies for low volatility, quality growth and yield.
However, the idea that these products can continue to deliver robust returns is predicated on the assumption that economic momentum will wane and the five deflationary factors that have depressed inflation in a major way for almost a decade – fiscal tightening in the eurozone, the China effect, lack of wage growth, suppressed commodity prices and the growing influence of discount retailers – will remain dominant.
«Fiscal drag has become fiscal stimulus»
Conversely, we would point to the fact that December’s leading indicators are in fact eclipsing the peaks witnessed in 2007 and 2011, consumer confidence across Europe is starting to reach new highs and each of the five deflationary factors have already very visibly turned. Fiscal drag has become fiscal stimulus, China reversed course recently, labor settlements are rapidly rising, most commodity prices are up 50 percent from trough levels, and the discount retailers are no longer pursuing market share at any price. Yet, European value stocks continue to be priced for a deflationary scenario.
It would appear that the reluctance to engage in value stocks is based on the perception that certain disruptors will prevent the usual cyclical forces from asserting. Let’s deal with each of these in turn.
Shale eats it all: In June 2016, the price of crude oil slipped back to around $46 per barrel as U.S. production numbers started coming in ahead of expectations. The specter of shale disrupting the market reared its head once more. However with the most efficient acreages, employing the most efficient rigs and the most efficient teams now harvested, major shale players will have to accept much lower efficiency and, therefore, higher break-even levels. With OPEC’s decision to extend output cuts, we expect OECD inventories to fall and oil prices to spike, as the oil market is pushed firmly into deficit by the end of the year.
Amazon eats it all: Last year, Amazon acquired Whole Food and announced price cuts on a select 15 products of 50 percent. This was taken by the market as a sign that high street food retailers would be priced out of business by the online giant. Amazon specializes in procuring, storing and disseminating hard goods with no expiry date in huge quantities at massive discounts. However, the fresh foods business is a totally different ball game. The belief in the market is obviously that Amazon can fix it. But after 18 years of trying, they seem to be falling further and further behind the leading incumbents rather than catching up.
«Continental European banks are among the most attractive investments currently»
Tesla eats it all: In August 2017, the belief that electric vehicles from Tesla would decimate the traditional auto market led to share-price capitulation among original equipment manufacturers, or OEMs. However, the likes of Daimler and VW have made significant progress since the carbon dioxide emissions scandal of 2015, developing very credible strategies for electric vehicles with detailed product roll-out schedules across the whole product range. These firms are experts in design and are making much bigger commitments to research and development than Tesla, which is massively leveraged and burning cash.
Fintech eats structurally challenged banks: It has become such a cliché to refer to banks as structurally challenged that many investors blindly repeat the phrase. However, the major reason that returns on equity halved over this period is that, by 2017, banks were required by regulators to hold more than twice as much hard capital as they had to back in 2007. This is a simple mathematical function of numerator and denominator and has little to do with the banks’ earnings power.
I consider continental European banks, which are trading below book value and on single-digit forward earnings – despite offering growing dividend yields of some 4 percent on modest pay-out ratios of 45 to 50 percent, with the added potential for share buy-backs – to be among the most attractive investment opportunities currently available in the value universe.
Are we in for a return to valuation-based stock pricing?
«Once this development accelerates, true value investors are most likely to be back in the limelight»
Even though value once again performed miserably in 2017, we are seeing early indications that some of the low volatility – quality growth – yield momentum trades are gradually grinding to a halt, heralding a return to valuation-based stock pricing, through which fundamental dislocations would have to be corrected. While it is possible to extract alpha from value stocks even in a pro-growth environment, the good news is that the rotation back into value, which should highlight the value of stock picking, has scarcely begun. Since the low point in February 2016, value has only outperformed the market by a mere 3.7 percent. Once this development accelerates, true value investors are most likely to be back in the limelight.
Hans-Ulrich Jost manages Euroland equity funds. He joined GAM Group in April 2012. In the past 25 years he managed Euroland equities at UBS, global equities at Globvest and Morgan Stanley, Pan-European equities at Schroders and U.K. and Irish equities at SBC Portfolio Management International. He graduated as an economist from the School of Economics and Business Administration in Zurich.
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