While we firmly believe that value investing is alive and well and we are as committed to it as ever, we have seen some value investors starting to change their strategies to other approaches that have delivered stronger performance in recent times.
This is not abnormal. Over the years, various value investment managers and their strategies have fallen out of favour from time to time. This is unfortunate as the reality is that over the long term, value investing has proven to outperform other investment approaches.
Berkshire Hathaway - run by Warren Buffet - has outperformed the S&P 500 by a very significant margin over many years despite shorter periods of under-performance. Even in the last twenty years there have been three distinct periods - 1998 to 2000, 2002 to 2006 and 2008 to 2012 - where Buffet's investment vehicle significantly underperformed the S&P.
In the first period, the under-performance was 80%, in the second it was 60%, and in the third, almost 65%. Yet despite these setbacks, Berkshire Hathaway delivered more than double the performance of the S&P 500 over the full period. This demonstrates that although a value investor's returns will look very different to those of the market from time to time, value investing still outperforms in the long run.
From a South African point of view, the FTSE/JSE Value Index underperformed the overall index from its inception in 2004 to the end of the last bull market in 2007. This was followed by a period of significant out-performance during the financial crisis and up until the end of 2011. For the last three years or so, the Value Index has severely underperformed the market and this trend seems to have gathered pace. That the Value Index has underperformed the overall market in South Africa since 2004 is an anomaly in global terms. All the studies in markets around the world show that value investing has outperformed most other forms of investing over time.
Many investors believe that they can guard against under-performance in an investment portfolio by investing in quality and popular businesses, as these stocks will provide them with an element of safety and have the ability to grow their earnings even in uncertain economic times. We believe that these quality and 'safe' businesses are currently very expensive and therefore may present a risk of permanent capital loss in the long term.
Market pays too much
For example, in the last 40 years defensive companies in the European market have only been more expensive relative to the rest of the market 4% of the time. The market is paying too much for the security and safety that comes from owning these so-called quality assets. We have learned that when you pay too much for an asset, it is unlikely that you will get a good return.
In South Africa, we believe that the market is expensive in aggregate and that a huge valuation discrepancy has appeared over the last two and a half to three years.
The graph below compares the price-to-book ratio of the Resources Index to that of the Industrial Index. In 2007/2008, resources companies were incredibly expensive relative to the market, trading at twice the price-to-book valuation of industrial stocks. This has turned around significantly, since then and resources now trade at 30% of the valuation of industrial companies.
This tells us that the market expects the current tough conditions in some of the resources companies to persist for a long time. At the same time, the good conditions currently being experienced by industrial companies - mostly those that don't operate primarily in South Africa but are listed on the JSE - are expected to continue going forward.
To us, this indicates that investors are paying too much for the safety of knowing that these companies don't operate in South Africa, the good run they have had in the last three years and the illusion of predicting the current good earnings out for the next couple of years.
We find ourselves drawn towards companies priced for continued bad performance where all obvious optics around these companies are negative. The current market environment, which has resulted in value investors falling by the wayside, is therefore creating an opportunity for us to construct portfolios with assets which are incredibly cheap within a market that is generally overvalued.
We therefore believe that the downside in our portfolios is limited and the upside potential is significant.
