Considering the number of ‘value’ investment houses in South Africa, one would imagine the price of value stocks had been chased up. However, recent research by Cannon Asset Managers demonstrates that the opposite is true — it is growth stocks that have become over-priced and value stocks show, if anything, even greater value.
Though the domestic equity market has reversed much of the initial deep damage inflicted by the 2007/8 market collapse, much of that running has been done by many of our well-loved growth stocks which represent well-run South African companies. Their current multiples have become extremely demanding and therefore high-risk. By contrast, value stocks have been largely overlooked, presenting exceptional opportunity.
Geoff Blount, CEO of Cannon, explains what has been happening: “The exuberance normally associated with growth style markets has been lacking,” he says, with the result that the outperformance enjoyed by these shares has possibly gone unnoticed. This is creating incredible opportunities for investors that are prepared to look to unpopular sectors of the market, which have been further accentuated by the recent market fall.
Higher levels of earnings growth
Andrew Newell, Cannon’s head of Business Development, says: “While one-year trailing price-earnings ratios (PEs) are a good measure of value, the cyclically-adjusted price earnings (CAPE) ratio even better reflects a company’s underlying value. This is because the CAPE ratio uses seven-year, or through-the-cycle, earnings of a company in the denominator of the PE multiple. In so doing, the CAPE ratio removes the noisiness of volatility in a company’s earnings.
“The less-volatile seven-year earnings growth graph has turned the corner and started to show a higher level of growth, while the one-year earnings growth graph has galloped ahead. This is a traditional signal that the underlying trend is towards higher levels of earnings growth,” explains Newell.
The market’s current average CAPE is 13,7 times, which is 15% lower than the historical long-term average or valuation threshold of 16 times, where it sat just before the recent pull back. This makes the market as a whole appear attractive. “However, of even greater interest is the rising dispersion of valuations across stocks within the market in the recent past, which is creating even more compelling investment opportunities as well as presenting notable specific risks.
“These rising valuation differences between expensive or attractively priced shares are in part explained by the exceptionally loose global monetary policy, embodied in the two phases of quantitative easing (QE) in the US. Specifically, QE has resulted in mispricing the cost of capital which, in turn, has pushed up asset prices and created speculative bubbles in some pockets, rather than stimulate the real economy as intended,” says Newell.
Blount adds: “In this vein, in South Africa, speculative or easy money has chased larger firms that are big enough for foreigners to be active in. These capital pools have also pursued anything linked to the Chinese or African growth stories or stocks with high earnings growth forecasts related to a ‘good story’. History, however, teaches us that rosy forecasts by investors very seldom materialise.
“Over the last few years, already-expensive shares have risen in price and underpriced shares have become less-demandingly priced. It is worth noting how demanding the valuation multiples have become on some of the currently-popular companies. While many are good businesses, investors are overpaying for these companies but appear to have forgotten that the easiest way to turn a great business into a bad investment is to overpay for the company. No matter how good the story, most of these highly-rated popular shares will ultimately disappoint investors,” says Blount.
Since December 2008, the difference between the bottom and top quintiles has widened from 11,9 to 13,5.
“This widening is characteristic of a growth market, with expensive stocks becoming even more expensive. This is not sustainable. As we know from past experience, at some point growth becomes exhausted as investors are disappointed by the inability of even the best-run firms to sustain aggressive expansion. It is at this juncture that the exceptional opportunity resident in value stocks becomes recognised by the broader market, with the resultant performance that makes deep value the best-performing investment strategy over time.
“However, most investors do not have the patience to remain loyal to the strategy long enough to reap the rewards and either get enticed into seductive growth stories or try and style rotate, all the more easy considering that buying out-of-favour value stocks is emotionally incredibly difficult to do,”