Seeking Value in Modern Global Markets

In this article we consider three topics:

1. Why are active managers underperforming?
2. What does successful value investing look like in modern global markets?
3. The challenge for pension funds - where to invest in a low growth world?

Underperformance continues to plague the fund industry. Nearly three out of four active fund managers in the UK have underperformed over the past decade*

There are many factors that have contributed to active managers' underperformance, including:

• Technology, anyone with a credit card and an internet connection can now be a portfolio manager
• Quantitative easing, leading to increasing correlations; and
• Regulation and compliance, companies are better than ever at protecting information

While these three factors certainly impede performance, we believe that the number one culprit for industry underperformance is short termism – a feature which is visible across the entire investment value chain. This claim is evidenced by three examples: 1) myopic sell side research – analysts are focusing on short time periods when considering company fundamentals, financials and performance; 2) the calendar year curse, the industry rewards managers for short term success with 'Manager of the Year' awards and other such accolades. Plus managers are increasingly scrutinised and expected to report to clients on a short term (monthly or quarterly) performance cycle; 3) the shrinking holding period for global stocks, which has reduced from almost four years to less than one in the past forty years (see figure 1).

Figure 1 – The average holding period for global stocks has decreased by 75% over 40 years

Source: World Data Bank

Short termism may incite behaviour that resembles reckless speculation rather than sound investing as investors try to predict (or perhaps more fittingly - guess) next year's best performing sector or asset class to make a quick buck. Very few (if any) manage to consistently make the right short term calls. This can be seen in the poor record of analysts in predicting commodity prices. So what's the alternative?

Modern Global Value Investing – a pragmatic unconstrained approach

It is often cited that 'Value' managers have struggled over the past decade but what is 'Value' investing? A Google search will lead you to any number of definitions and interpretations, such as:

• Value investors are: "investors who are focused on paying a relatively low share price in relation to earnings or assets per share" CFA Curriculum
• "Value investors buy low PE stocks" Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU
• "All intelligent investing is value investing - acquiring more than you are paying for" Charlie Munger, Vice Chairman of Berkshire Hathaway

For the record, no definition is necessarily more correct than the others. However, the world is a constantly changing place as evidenced by the huge fluctuations in interest rates, the political landscape and the prospects of global trade over the past 15 years. Hence, we think it's vital to focus on company fundamentals and to have a pragmatic and dynamic approach to value investing; where discount to intrinsic value is an absolute criterion but where value can be found in many different guises. Too often, managers are boxed in by a restricted mandate, limiting their ability to outperform. Put differently, investing blindly on one valuation metric, such as the P/E (Price to Earnings ratio) or P/B (Price to Book ratio), limits flexibility; at the same time investors need to strike the right balance of maintaining restraint on pricing while avoiding the urge to enter optically cheap value traps. Admittedly, this simple guideline is often easier said than done. Nevertheless, Warren Buffett elegantly conveys the message in his quote , "We don't have to be smarter than the rest. We have to be more disciplined than the rest."

Example: Investors would have lost out by sticking with this very low P/E energy company (blue line) based on price alone, or riding the wave of the pharma company (green line) for too long.

Sell discipline is vital – both in sticking to your price targets when companies achieve the triggers in your investment thesis but also in admitting when things may not be progressing according to plan.

Figure 2 - Being more disciplined means avoiding both the darlings and the value traps

Source: Bloomberg, SKAGEN

Finally, managers frequently look for the thrill to score big on each and every investment. However, this approach is fraught with danger. Truly outstanding investment opportunities are rare. Finding them requires patience, discipline and a contrarian mindset; therefore, bargain hunting is not a group activity and does not cater to those looking for quick wins or instant gratification. But the rewards for those with patience are often sizeable. While waiting for that big bargain to show up investors should remain prudent and avoid both the darlings and the value traps to secure long term success. This approach will not lead to top quartile performance in every calendar year but should lead to consistently strong returns and outstanding performance over the long term.

The challenge for pension funds – where to invest in a low growth world?

Low volatility stocks have been enjoying their moment in the sun but we think that their valuations are now looking stretched and we could be in a low volatility stock bubble. The key is to separate the undervalued stocks with low volatility characteristics from the overvalued stocks which have benefited excessively from the low-volatility wave but no longer have the fundamentals to support the valuation level.

Figure 3 – A low volatility stock bubble?

Source: Factsel, CRSP and Bernstein Analysis

We see three dislocations in the current equity market:

1. Current valuations suggest that bond-like equities have a low future expected return (or that there will be a continued fall in interest rates). We see significant value (current high equity risk premiums) priced into stocks where earnings have already been hit by the fall in interest rates.
2. Current valuation implies that high ROE (Return on Equity) / high P/B companies with limited growth and high pay-out ratios create shareholder value but we call these stocks "fake" compounders as they are often companies that are unwilling or unable to reinvest into the business. In a low-growth world, we prefer low P/B companies with a high FCF (Free Cash Flow) conversion and high payout ratio. Current valuation fails to reflect the actual long-term value in select franchises as short-term price movements typically dominate the debate.
3. As long-term investors of pension assets, we also seek to have meaningful exposure to structural winners which seemingly are perennially undervalued by the market.

We buy companies for their long term capital appreciation potential and favor those that are masters of their own destiny, with limited influence by external factors. We buy companies that we have analysed and understand and this, for us, is the meaning of true risk management. This means that our sector and country exposure is driven by our conviction in companies, not by the index. Buying the market (index) implicitly means buying the bubbles. Prudent active equity managers will likely prove their worth when the next stock market bubble suddenly bursts.

Figure 4 – Buying the market (index) means buying the bubbles

Source: MSCI and Bernstein Analysis

At SKAGEN we define success as delivering long term outperformance that is consistent, explainable and repeatable. In order to achieve this we use the following framework:

Source: SKAGEN, as at 31 October 2016. Data provided is for SKAGEN Global A, inception date 07/08/1997.* Based on GBP returns for SKAGEN Global A, net of fees.

In conclusion, we believe that in a low growth world pension funds can benefit from an allocation to a truly unconstrained and active global equity portfolio in order to help bridge the funding gap. To ensure the portfolio has the best opportunity to outperform, the manager should have a proven philosophy, allowing the trustees to have confidence through tougher performance periods towards a long term investment horizon. Rather than periods of weaker short term performance, we think that scheme governors should be concerned with signs of short termism, straying from the communicated philosophy or anchoring to a benchmark index. Specialist investment boutiques, with a strong equity investment performance culture, rather than a product sales culture, can offer the right framework to achieve consistent, explainable and repeatable, long term outperformance.

*Tanya Jeffries for thisismoney.co.uk, 24 March 2016