It's Different This Time, Not A Bubble

One of my all-time favourite movie scenes is when Woody Allen stands in the queue in Annie Hall (1977) and he ends up having a discussion with the loudmouth academic behind him who professes to know everything there is to know about Marshall McLuhan.

To prove his opponent is more talk than substance, Allen steps out of the camera frame and returns with Marshall McLuhan who tells the academic you're wrong and Woody is right; you should not be allowed to teach any students about me.

Replaying the scene today via Google over the Internet makes the whole act seem a bit out-of-date, but it's the surprise act that has stolen my imagination.

In my naughtiest dreams I see yet another assembly of value-investors appearing on Sky News Business, talking bubbles and investor exuberance, and how all the money flowing into stocks like CSL ((CSL)) and Bapcor ((BAP)) is like playing Russian Roulette; inevitably this story is going to end in tears and it will be ugly, they assure.

But then James Daggar-Nickson, or one of his female host colleagues, calls out my name and I step from nowhere inside the TV frame, telling the experts: you have been wrong for the past five years, what makes you think you are right this time around? Personally, I think you will be proven wrong a lot longer.

Stock pickers and value investors

If the past five years have taught me anything about the Australian share market it is that most expert investors are, essentially, bottom-up stock pickers. They might join the general debate about what governments should do, or what the outlook looks like in terms of central bank policies and global economic growth, but that's not really their forte.

Bottom-up stock pickers are usually synonymous with value-investing. They find opportunity among stocks that have fallen out of favour and in price. The analysis is concentrated mostly around what the company can and should do to turn its fortune around. At its centre sits the age-old piece of market wisdom that a young Warren Buffett once upon a time received from his mentor, Benjamin Graham: no matter the timing or catalyst, any asset that is undervalued will be priced at true value, at some point.

Enter that other, equally enigmatic ingredient determining success and failure for investing in the share market: investor sentiment. We all prefer to be riding the upward trending slope, but it's not always clear why we are or aren't.

But if most of our attention is spent on identifying individual opportunities, we are bound to miss a broad change in the general investment climate and this is exactly what has occurred in the past five or six years. Look no further if you want to know why most strategies and most managed funds have failed to even keep up with local share market indices over that period.

On my observation, many are seeking solace behind that old John Maynard Keynes statement in that the market can stay irrational longer than you can stay solvent. The underlying implication here is that increasingly popular passive investment products such as ETFs, combined with robots and investors herding behind shorter term momentum, have created a temporary market distortion, but time should do its healing, as it always does.

Many a market update published by value investors today starts off with the old warning from Sir John Templeton:

"The four most dangerous words in investing are, 'it’s different this time'".

But is this really all there is to it?
 

10 years of underperformance

Morphic Asset Management joint Chief Investment Officer Chad Slater, also part of the value investment community, last month published an analysis that suggested in the USA "value-investing" has essentially been the underperformer ever since the GFC, which means the whole past decade.

Slater also refers to analysis published by O’Shaughnessy Asset Management showing "growth investing" has now outperformed "value" in every single sector in the US since 2010.

On my own analysis, the gap between "growth" and "value" in the Australian share market started to become noticeable from 2013 onwards. This aligns with research published by analysts at Macquarie and stockbroker Morgans, so I think we can safely assume that what apparently started in the US some ten years ago is now on the verge of completing its sixth year in Australian shares.

A long time for something that supposedly is but a temporary bout of irrational greed gripping equities locally and elsewhere.

If one really wants to put the knife in, consider the following observation by Slater: "...since 2007, this recent period of value investing lagging growth has been so severe that value investing has given back all its gains since 2002 and now we are back to where it was in 1988".

Maybe typical for the art of bottom-up stock picking, many critiques about buying the overly expensive Healthcare Champions or IT Copycats is based upon rather one-dimensional analysis. It goes like this: companies such as CSL, ResMed ((RMD)) and Cochlear ((COH)) used to have higher growth rates 10-15 years ago, yet their valuation (PE ratios) has increased substantially. This does not make sense. Irrational exuberance. Sell.

Before we come to such conclusion, let's have a look at the other side first. Everybody agrees calling BHP shares "cheap" because on two earlier occasions (2007 and 2011) the shares traded near $50 is not a correct measure for valuing the stock today. Conditions and circumstances were a lot different then from today; it's a sharply different environment. BHP shares do not deserve to be trading near $50 anymore.

The same argument can easily be made for CommBank shares, which do not belong near $96 today, or Harvey Norman, or G8 Education, or Myer (and so many others). As over-ruling circumstances have changed dramatically, these stocks are anno 2018 all trading at a valuation discount versus historical trends and averages, and even the value-investors themselves agree this seems but justified.

When it comes to assessing CSL, ResMed, and the like, one key factor has changed here too: 10-15 years ago these companies were fast growing in a general environment that offered plenty of alternatives, including banks and other financials, miners and energy stocks, plus most other cyclicals, even retailers and telecommunication companies.

One-dimensional analysis whereby today's growth companies are only being assessed against their own past misses the crucial point that, on a relative comparison, today's high quality, high growth companies, and that certainly includes CSL, Cochlear, ResMed, as well as REA Group ((REA)), Bapcor, TechnologyOne ((TNE)), and others, are standing out much more than they ever did.

So, in essence, large parts of the share market today are trading at a discount to their traditional valuation because these companies are now facing more challenges and threats, and they find it (much) harder to grow and create shareholder value, while in most cases the quality of the growth achieved is much less too, and consistency has gone out the window.

Enter asset sales, cost cutting, price discounting, lower tax rates, acquisitions, share buybacks and restructurings instead of good old fashioned sales growth combined with healthy margins.

Surely everybody agrees the latter is preferred, in particular when combined with sustainability, reliability and market leadership?

Why Macquarie demands a premium

One fine example of O’Shaughnessy Asset Management's assessment here in Australia has been provided by Macquarie Group ((MQG)). Veteran banking analyst Brian Johnson had already started calling for a structurally higher valuation for Macquarie pre-GFC  but for many years the shares offered similar dividend yield as most other financials in Australia, including the Big Four Banks.

This only changed recently. Macquarie shares are now offering a consensus forecast (forward looking) yield of 4.5% which implies a significant valuation premium vis-a-vis other banks, and even Australian financials in general. The Big Four are now offering 6%-7%+.

While we can all have a debate anytime about whether Australian banks are cheap, too cheap, or not at all, it is difficult to argue Macquarie Group shares do not deserve to trade at a relative premium. The gap between Macquarie and the rest of Australian financials was once again highlighted in a broad reaching sector assessment by another veteran researching banks and insurers in Australia, Brett Le Mesurier, now at Shaw and Partners.

On LeMesurier's latest assessment, Macquarie is the only financial in Australia poised to achieve significant top line growth for at least the next two-three years. In terms of growing earnings per share (EPS) for shareholders, only Suncorp ((SUN)) seems positioned to (potentially) perform better, but this comes after a disappointing period during which growth was actually negative and Suncorp's immediate outlook is also supported by asset sales.

Long suffering value-seekers might argue low expectations might give the banks and insurers such as QBE Insurance ((QBE)) and Insurance Australia Group ((IAG)) an opportunity to surprise to the upside, which is valid, but it's not like the sole option left for Macquarie is to disappoint at next year's full year result release. As a matter of fact, most analysts think the bias remains in favour of Macquarie lifting its guidance between now and then.

LeMesurier makes a point of highlighting how severe the challenges and risks are for AMP ((AMP)) and Challenger ((CGF)) in the sector.

Macquarie's well-being, of course, is much more aligned with asset markets and investor sentiment globally, but, irrespective, the Shaw and Partners report highlights the consistent revenue that Macquarie has returned on the employment of its capital over the past decade, described as "an extraordinary performance in view of the different market conditions that have existed over that period".

Strictly taken, and this is pretty much a view carried across the community of analysts covering the company, growth at the Golden Donut is slowing, and is likely to be lower in the years ahead vis-a-vis the years past. But it continues to stand head-and-shoulders above the rest in the sector.

Only by also including the second factor can we justify, and understand, the valuation premium that has been priced in Macquarie shares. What goes for Macquarie, also applies to CSL et al.

The most famous words in finance

Contrary to those who use Sir John Templeton's famous quote to argue markets have gone temporarily off the proven and tested script, I have been arguing for years now this time IS different, times have changed, it's a different context altogether from pre- and immediately after the GFC, with changing operational dynamics significantly widening the gap between Haves and Have Nots in and outside the share market.

At least Chad Slater is candid enough to acknowledge value investing is, in its essence, buying lesser quality companies in the hope they can overcome their challenges. In the overwhelming number of cases, this has proven to be a bigger-than-usual challenge, which is why detailed analysis, by OSAM, Slater and by others, reveals many "cheap" looking stocks post-GFC have simply proved to be "value traps".

This is also why the share market since 2013 has so clearly favoured quality above lesser quality, yet another characteristic many a value-investor finds it difficult to grapple with.

This is not to say investors should no longer pay attention to valuation when adding shares to their portfolio. Relying on the past, however, or using High/Low PEs as the sole point of reference is almost guaranteed a recipe for disappointment, as has been proven in the years past.

As to what is needed to break the market's obsession with Growth over Value, I'd suggest a dramatic change in overall dynamics, such as the Reflation Trade-inspired portfolio switching in the second half of 2016. Ultimately, that switch, which took place in a different context, only lasted for five whole months.

For all the value investors out there who cannot but stick to the script, here's the advice from Chad Slater, quoting hedge fund trader Paul Tudor Jones:

"You adapt, evolve, compete, or die."

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