Summary

In August of this year, our paper Value vs Growth and the Divergence to the Extreme highlighted the fact that value as a style has been significantly out of favour for some time, particularly in Australia over the past year and a half. Three months on, and with heightened volatility in markets, we reflect on that sentiment and provide an update on what’s driving markets and why patience pays off.

Putting markets into perspective

Chart 1: S&P growth/value ratio

Chart 1 S&P500 growth/value ratio

Source: S&P, Nikko AM

From the Australian perspective, where the ratio is inverted, you can see in Chart 2 that growth has once again outperformed value (since April last year), after outperforming value between late 2014 to late 2016.

Chart 2 MSCI World value relative to growth

Chart 2 MSCI World value relative to growth

Source: Deutsche Bank

Chart 3 Total returns by style

Chart 3 Total returns by style

Source: Deutsche Bank

During August, we saw the value/growth divergence become particularly heightened. Despite delivering below average earnings during reporting season, the high PE stocks saw an even higher PE multiple expansion.

In Chart 4, which cover the month of August 2018 only, you can see the highest PE bucket during the August reporting season went up 4.24 PE points, and the second highest went up 0.76 PE points. This was all about PE expansion in the most expensive stocks.

Chart 4 PE expansion in PR multiples

Chart 4 PE expansion in PR multiples

Source: JP Morgan

Unsustainable PE ratios

PE expansion in the expensive stocks has been going on for some time, as shown in Chart 5. From early 2017, while growth stock PEs re-rated upwards, value stocks have had their PEs de-rated. This is not driven by earnings growth, but concerns about subdued economic growth driving the market to sell down economically sensitive stocks (in the value bucket), and buying up growth stocks that are perceived to be immune to the economic cycle. The differential in PE ratios is currently about double the historical norms, and is clearly not sustainable and would be suggestive of mean reversion.

Chart 5 Chart 5 MSCI Australia forward PE ratios

Chart 5 MSCI Australia forward PE ratios

Source: Deutsche Bank

In fact some of the high PE stocks disappointed on expectations, but continued to surge higher during the month. The low PE stocks (the value stocks), on the other hand, got punished mercilessly even on slight missteps, which included our largest active weight position in Iluka (ILU). ILU fell about 19% that month, on what was effectively a 3% earnings downgrade on higher costs. While there are some other names to add to the list of casualties, the key driver of the performance during the August reporting season was an elevated level of irrational behaviour by the market in chasing growth stocks at any price while selling down the value stocks regardless of how cheap they were.

A punishing October

During the month of October, the market became concerned about a possible recession in the US from rising interest rates, as well as heightened concerns about the trade war between the US and China.

As a result, October was a period of heightened risk aversion with the Australian market down 6.1%. This was when the market saw a massive flight to safety. The beaten-down cyclical/economically sensitive value stocks (where we are actively positioned), and the hyper-growth stocks were punished. What outperformed were those stocks that were neither pure growth nor pure value, but sit in the quality camp and are seen to be very defensive in times of fear. These included the gold stocks, the REITs, utility and infrastructure stocks, Woolworths, Coca Cola Amatil, Telstra, some of the healthcare stocks, and, interestingly, RIO which was about to embark on a $4.4b share buyback.

Those managers with a meaningful ‘quality’ or ‘bond-proxy’ feature in their style may have held these types of stocks. Ironically, bond-proxy stocks outperformed in October due to concerns about economic growth arising from fears of rising interest rates, when intuitively, one would expect bond-proxies to fall from fears of rising bond yields. Again, a feature of an irrational market.

Chart 6 shows what happened during the month of October. In the blue, you can see that Quintile 3 had positive PE expansion, while Quintiles 4 and 5 (the value buckets) had massive de-rating. As previously stated, the quality and defensive stocks are neither pure growth nor pure value in this current climate, and as such would feature in the middle quintiles. This explains why Quintile 3 had the biggest PE re-rating during October. Whereas the cheapest buckets (quintiles 4 and 5), continued to get punished via a continual PE de-rating.

Chart 6 PE expansion as a % of PE multiple

Chart 6 PE expansion as a % of PE multiple

Source: JP Morgan

Chart 7 shows how dramatic the PE expansion has been over the 12 months to 31 October 2018 for the highest PE bucket (growth stocks), and relative to the cheapest buckets, which have been even more dramatic.

Chart 7 PE expansion in PE multiples over 12 months

Chart 7 PE expansion in PE multiples over 12 months

Source: JP Morgan

History often rhymes

We only have to look back in history to see periods of similar or greater underperformance for value managers, and in each and every case, sanity did return to the market, with these bubbles eventually bursting. This resulted in value managers more than recouping their underperformance leading up to the peak of the bubbles in subsequent periods after they burst.

These periods included the bottom of the GFC in late 2008 to early 2009, the heightened periods of the commodities boom in 2005/2006 (as well as 2010), and during the Asian Financial Crisis in 1997 and the Tech/Media/Telco boom in 1999 to early 2000. Each of these periods delivered significant underperformance for value managers.

During the Asian Financial crisis in 1997 we saw cyclicals and other economically sensitive stocks sold off and the safe havens massively outperform. This was due to major concerns about global economic growth and, in particular in the Asian region, the “Asian Tigers” which faced a cathartic experience (Minsky moment) when their currencies were sold off on concerns about very high levels of debt in their major corporates.

The Tech boom was largely about an extraordinary price bubble that formed in tech/media/telco companies which distorted equity markets, while traditional cash generating companies were sold down to buy into these growth stocks.

In each of these periods there were always the doomsayers or the ‘Chicken Littles’ saying, “It’s different this time”, when arguing why they expect the irrational market conditions to continue on, and not mean revert to more normal levels. Well, history showed they were wrong, and that the market did eventually normalise, and history would suggest that it will not be different this time either.

A return to normalisation?

So, what is the catalyst for this normalisation or mean reversion to occur? This is a great question. Sometimes there may be a catalyst, and other times there will not be one. While it is difficult to predict turning points, we currently see two potential catalysts in the next six months. The first is the easing of financial conditions in China, given their tightening 18 months ago is probably the cause of the current China/Europe slowdown. The reversal of monetary tightening can be seen in Chart 8, which is derived from liquidity indicators such as the Shibor and reserve requirement ratios.

Chart 8 Financial Conditions Index

Chart 8 Financial Conditions Index

Source: BofA ML, CEIC

It takes about six months for the transmission mechanism to work its way through the real economy.

Chart 9 FCI against Chinese electricity output

Chart 9 FCI against Chinese electricity output

Source: BofA ML, CEIC

The second potential catalyst for value realisation is the continued delivery of strong corporate earnings. Corporate earnings expectations have been met in the past two years. This is in contrast to the historic average of 8pp decline in earnings expectations to earnings delivery. Australian corporates most recently delivered 7% yoy growth, while the US just delivered almost 25% EPS growth and over 15% growth stripping out tax benefits. Confidence in these earnings being delivered will lead to the removal of the premium for growth stocks./p>

Chart 10 Evolution of earnings growth forecasts

Chart 10 Evolution of earnings growth forecasts

Source: IBES, Datastream, Deutsche Bank

As previously stated, there may not be a catalyst and the market will inexplicably just self-correct like it did during the bottom of the GFC in early March 2009, when it turned on a dime after another torrid morning session. The key point is to remain disciplined, and to be well positioned to benefit when the value snap back happens. When it does, it can be quite ferocious and if you are not set because you are waiting for the right moment, you may miss most of the rebound. It is during this price reversion that a patient active value manager like Nikko AM Australia can benefit enormously.