Value managers of Australian equities are waiting for the real economy to catch up with their portfolios. SIMON MUMME speaks with some value veterans about the prospects of a big recovery for their style.
Their results became public knowledge in mid-October. Value managers, the traditional preservers of capital in tough times, have registered their one-year gross performance figures since the onset of the bear market: some outperformed the market by 6 per cent or more, others hovered close to the index. Some lagged it.
Investors Mutual and Maple-Brown Abbott recorded the top returns among value managers for the year ending September 30, returning -20.6 per cent and -20.7 per cent respectively, against the –26.76 loss from the benchmark ASX200. Further down the rankings, Dimensional posted -21.0 per cent and Tyndall –23.8 per cent, while Bernstein underperformed, losing investors 29.8 per cent for the year.
These one-year performance figures are meaningful because it is at this time, after the widespread sell-downs marking the beginning of a bear market, that value managers’ long-held positions have historically rewarded them. It was roughly one year on from the height of the dotcom boom that Australian value managers compensated investors for years of underperformance, generating big gains through holdings in unloved, ‘old world’ stocks, such as resources. John Kightley, managing director of Maple-Brown Abbott, says the return generated by the boutique’s Australian Equity Trust for the quarter ending in September charts a similar pattern to that following the dotcom bust. The 5.1 per cent outperformance, relative to the benchmark, is second only to that recorded in the June quarter of 2000. Most of this gain, 4.1 per cent, can be attributed to stock selection, since the trust is composed 96 per cent of equities.
The outperformance was generated by an underweight allocation to the resources sector, and an overweight to defensive stocks such as Fosters and Coca-Cola Amatil. Only 0.5 per cent of the quarterly gain can be attributed to cash holdings, which account for 4 per cent of the trust. But Kightley is still not convinced that corporate earnings are adequately reflected in share prices. In its balanced fund, Maple-Brown Abbott has increased its allocation to equities from 32 per cent in 2007 to 37 per cent, but is still underweight the market. Its exposure to cash stands at 13 per cent, compared to 18 per cent in 2007. “What we see as good relative to cash is not sufficient yet to make us go overweight. It might take a while for earnings to catch up,” Kightley says.
For Bob van Munster, the head of equities at Tyndall Investments, the value recovery in the wake of the resources boom has not yet begun. “The macro factors are overwhelming any factor overall,” he says. “The world is long on pessimism. When risk appetites start to improve, value strategies will work.” While lower interest rates could spur institutions to redeem cash holdings in preference for higher yields from the equity market, investors are, Van Munster says, now similar to retail shoppers who like the look of plasma televisions on sale for $3,000, but remain hesitant to buy for fears the price may go to $2,000 a few months later. For Kightley, a big value recovery will not depend on confidence returning to the market, but the relative price movements of securities that are judged as capable of outperforming their peers.
In short, companies with strong balance sheets, minimal leverage and attractive four-year earnings that are, for some reason, unloved by the market, will beat the index – at some future point. “We don’t forecast the market; there is no value in that. Market forecasts depend on sentiment at the time rather than the earnings. We can determine earnings growth, more or less. But price to earnings numbers are sentimentdriven.” There are three reasons why big recuperative gains might not be made from this bear market, van Munster says.
First, the differences between price to earnings ratios of high and low value companies are not as great; there will be fewer takeovers because debt is more costly; and the effects of this crisis on the broader economy are likely to endure longer than those of the last one. There are also value traps in listed property trusts (LPTs), which look cheap in terms of headline asset backing, but, due to high levels of gearing, are very sensitive to movements in the valuations of underlying assets. “They look cheap but we don’t know how far earnings are going to fall. It’s a short-term value trap.
The market has a short-term focus on the impacts on earnings,” van Munster says. Amid such opaque LPTs and financial stocks lie refinancing risks, Kightley says. “There were real earnings and cash flow in stocks doing well, like financials, listed property trusts and Allco. There were earnings, but a lot were manufactured and based on leverage.” Both managers say the effectiveness of their positions will be clearer when the financial crisis ultimately affects the real economy.
As pervasive as its impact may be, businesses and consumers will still use broadband internet connections and mobile phones, eat and drink alcohol and so on, Kightley says. Echoing their actions during the Asian crisis, van Munster says investors are gravitating toward companies with strong balance sheets, sustainable earnings and minimal leverage, such as big food retailers, health care companies and brewer Lion Nathan. But the impact on corporate earnings from the depreciation of the Australian dollar had still not been factored in.
While the market appears cheap, at a multiple of 11.3 times earnings compared to the long-run figure of approximately 15, companies that are financially strong should be sought, according to a quantitative research report published in October by Citi. This means profitable businesses with market share that can fund their operations and expansion, can meet future debt obligations and are operationally efficient. Since November 2007, signals for the quantitative factors of growth, quality, momentum and value have produced anomalous results, Citi finds.
Macro forces have determined the variability in returns, “swamping” all stock and style characteristics. In particular, value and quality have underperformed. The report, entitled ‘The Time for Value Investing Will Come’ argues that some resolution of the credit crunch and a return of confidence are needed for systematic strategies to perform. When companies bear the full brunt of the credit shortfall, value and quality are expected to perform. Citi expects the impact of the crisis on the real economy to be ugly – but it will show how extensively companies have been hurt. From this vantage point, quantitative analysis will be more effective.
According to Citi, value will perform “only when investors have regained their confidence in the financial system and earnings visibility improves”. Given that some commentators are predicting the impact of the credit crisis to continue for up to two years or more, value managers will be hoping this is not the case.
A BEAR MARKET HISTORY
It is more than one year since markets awoke to the subprime mess, and the bear market is still in an early stage, Kightley says. Bear markets typically begin with indiscriminate selling by market participants “there is panic, and people don’t pay attention to value” – followed by an adjustment to the new environment.
Those who offload stocks are generally only able to sell their most liquid holdings, resulting in bigger volumes of large and mid-cap stocks being put on the market. The next phase sees investors prepare for the impending effects on the real economy. The regional chief executive of La- zard, Rob Prugue, says the current turmoil is driven by the unwinding of one factor, price momentum, which he sees as the major determinant for resources stock prices throughout the last bull market and its decline.
The factor explains the “energy” created by a security as it outperforms or underperforms its peers, Prugue says, and can be especially potent in cap-weighted indices. Compared to other pricing factors, it became a key contributor to inflated pricing during the last bull market. “The market dynamics of the last 12 months has been more indicative of the unwinding of a single factor, rather than style metrics.”
The extent to which value managers can preserve capital in the bear market will vary because some employed price momentum as an execution tool during the resources boom, Prugue says. This allowed them to hold stocks as their prices rose, boosting their performance relative to value peers, but has detracted from their returns in the past year. “The value manager should preserve capital better in a downward market. They should have lost less money, all things being equal. But in the value categorisation there could be a large dispersion because of the influence of a non-style factor called price momentum.” Prugue argues that momentum has made the index more volatile, and that it produced unusually high tracking errors in the returns of benchmark-aware funds. “You presuppose that the index is neutral.
Its exposure to the cyclical materials sector has risen, which means that your exposure to materials is quite high.” Compared even to the tech bubble, the surge leading up to the crash of 1987 or the late-1960s conviction that an industrialisng Japan would grow perpetually, the last bull market was “abnormal”, Kightley says. Headlined by the skyrocketing price of BHP Billiton, the resources boom was driven by the price of commodities. But the resources companies also produced earnings, making them more difficult to identify as the drivers of an unsustainable bull run than many tech stocks were in 1999. “Resources companies looked to be value, but they were cyclical and at peak earnings. They were more difficult to analyse than tech stocks because those companies had no value, no earnings,” Kightley says.
The differences in valuations between good and poor companies was more dramatic in the tech bubble, van Munster says. “People were paying up to 35 times for growth companies, and eight times for so-called dinosaur stocks.” During the dotcom era, visitors to the Maple-Brown Abbott office at 20 Bond Street made jokes about the colonial aesthetic of the firm’s boardroom, with its stately boardroom table and book cabinets built from varnished wood, and prints of native flora on the wall. “We just didn’t get it, they said. We were ‘dinosaurs’,” Kightley says.
“This time around, it’s been people saying, ‘What if China keeps on growing?’ There are some investors who subscribed to a stronger-forever, more than a commodity super-cycle idea. Meanwhile we’re generally buying the least popular part of the market,” Kightley says.