There is little dispute that the world is currently experiencing very interesting times on all fronts and across regions. The question is: what does this mean for how we invest our clients’ money? As value investors, we believe valuation still matters.
Politically, the world is facing many challenges
On the political front, the ongoing tensions in the European Union threaten the continued existence of this grand economic experiment of European integration. In addition, there is conflict in the Middle East, the European refugee crisis, rising tensions in the China seas, regular provocative acts by the totalitarian regime in North Korea, and a major corruption scandal in Brazil, to name a few. Not to mention the possibility of a Trump presidency in the US.
On the social front, changing demographics are affecting entire societies
The “millennials”, the generation that grew up with computers, mobile phones and the internet, are taking over the reins from the “baby boomers”, who can still remember typewriters, rotary dial telephones and the introduction of colour television. In much of the developed world, populations are rapidly ageing. This is having a profound effect on the way these societies function and on their economic prospects. In Japan for instance, the market for adult nappies is now bigger than the market for baby nappies. In addition, more drivers over the age of 65 years are involved in car accidents than those under the age of 25 years. In Europe, the growing burden of providing the generous state-funded retirement benefits promised to the “baby boomer” generation has contributed significantly to the fiscal disorder in the region.
Economically, policy makers are struggling to stimulate growth
On the economic front, the global economy is still struggling to revive itself after the shock of the global financial crisis in 2007/2008. Policy makers have pulled out all the stops in their attempts to stabilise the financial system and restart economic growth. As a result, an unprecedented amount of money has been created and central bank rates are at all-time lows. The European Central Bank reduced its deposit rate to below zero in 2014 and since then, a few other central banks have also started charging depositors to hold their money. In January this year, the Bank of Japan joined this club in a surprise move that some saw as the last roll of the dice for “Abenomics”.
This challenging scenario is a serious concern to investors
Reflecting on the multitude articles about the global economy’s current maladies that are circulated in the media every day, it appears that investors are primarily concerned about three things. The first is the sluggish rate of economic growth. The second reason for concern is the persistently very low rate of inflation in many important regions of the world. Lastly, investors are concerned about the fact that every new round of central bank stimulus seems to be less effective.
The slow pace of economic activity and the shortage of business opportunities that this implies, appears to weigh most heavily on equity investor sentiment. Even in the US, which rebounded first and most vigorously after the financial crisis, growth remains weak despite almost a decade passing since the crisis (as shown in Figure 1). This is despite the unprecedented efforts of central banks around the world to stimulate economic activity and investment.
Declining growth in developed economies is proof of failed monetary stimulus
In addition to the disappointing rate of recovery, consensus expectations for medium-term growth in the world’s most important economies have been steadily declining. Figure 2 shows the rate of real GDP growth expected for the next 6-10 year period for the US, Germany and Japan at each date along the horizontal axis. It clearly shows how the expectations of a sustainable rate of medium-term growth changed over time. Although China, the world’s second largest economy, is not shown in the figure, it is common knowledge that its rate of growth has also slowed significantly and is expected to slow further. Investors clearly have their doubts about whether all the monetary stimulus that has been applied is going to have the desired effect. Just as antibiotics become less effective in healing the human body when taken continuously, the global economy seems to be developing some resistance to constant stimulus. As a result, each successive round of stimulus appears to be less effective than the previous one.
Negative policy rates are not having the desired effect
With global policy rates at all-time lows, the ability of central banks to provide further stimulus appears to be quite limited. Despite nearly two years of negative deposit rates in the European Union, growth rates in the region are still stalling. Japan’s experiment with negative rates is too new to draw any conclusions. However, judging from the mixed bag of economic data releases subsequent to the move, it appears that the market’s excitement might have been premature.
Disinflation in the developed world is still a threat
To make matters worse, inflation in most of the developed world remains very low (as shown in Figure 3) and the very real threat of disinflation or even deflation continues to loom in a number of important regions. Sluggish economic growth, the low oil price, depressed commodity prices and over-capacity in many sectors suggest that central banks are going to struggle to push up inflation. As long as disinflation or deflation is a threat, monetary policy will likely remain accommodative.
High levels of borrowing limits governments’ ability to intervene
Central banks are not alone in their growing impotence. Governments are also constrained in their ability to stimulate activity through expansionary fiscal policy, due to already high levels of borrowing. Although these high debt levels are currently manageable thanks to the very low interest rates, high debt would become a serious problem very quickly if rates rise meaningfully. The turmoil in equity and exchange rate markets surrounding the US Federal Reserve’s decision in December to raise the US interest rate after seven years (from close to zero) clearly indicates the markets’ awareness of this risk.
In these uncertain times, investors choose safety and pockets of opportunity
How and when these troubles will be confronted and resolved is unclear. There is no shortage of opinions about what should be done and what might happen, but we doubt whether anyone really knows. We are truly faced with a unique situation for which there is no quick or simple solution.
Confronted with this confusing and uncertain situation, investors have predictably opted for safety and the few pockets of opportunity that appear to exist. As a result, they are willing to tolerate negative real yields on government debt in many instances and to pay high multiples for “defensive” and “growth” equities. There has also been a stampede out of emerging markets in favour of the perceived safety of developed markets, particularly the US.
The market is currently obsessed with “growth” companies
This is clearly illustrated by the performance of the so-called FANG stocks – Facebook, Amazon.com, Netflix and Google (now Alphabet) – compared to the rest of the market last year.
Growth refers to earnings growth. It has been calculated from the historic and prospective price to earnings multiples for the four shares combined.
Figure 4 shows that these companies, that are currently growing at a faster-than-average rate, outperformed the overall equity market by more than 70%. It also shows that, despite delivering growth that was lower than expected, these companies received an even greater premium valuation than the already big premium they started with at the beginning of 2015. Supporters of the “growth” style justify these extreme valuations by pointing out that these companies delivered superior top-line growth under the current difficult conditions and expressing confidence that this trend will continue for many years to come. Valuation, it appears, does not matter if you can grow in a low-growth environment.
As value investors, we believe that valuation always matters
We therefore do not find these arguments persuasive. History has shown us that, although scarce growth often results in a premium valuation, that premium quickly dissipates when growth becomes more abundant. We believe that this pattern will be repeated when more generalised and widespread growth returns to the global economy.
In his most recent letter to shareholders, Warren Buffet discussed the enormous improvements in living standards achieved during the past two centuries and highlighted that this was due to the constant striving for greater efficiency and productivity. This is the “secret sauce” that has driven business performance and, as a result, equity markets throughout history. We believe that this drive to continually improve living standards is fundamental to the human condition. We also believe that it will ultimately lead us to a solution to the global economy’s current predicament and result in a renewal of more widespread global growth. When this happens, valuations will, as they mostly do, matter once again.
In the meantime, we will continue to invest in a selection of the many good quality companies that are currently out of favour because they are struggling to find exciting growth opportunities. In our opinion, this lack of excitement is more than adequately compensated for by their current valuation. It is clear that in this unprecedented time, investors’ patience and resolve will be tested.
By Douw Steenekamp