Quality now more important than value in Europe
‘Growth’ stocks are outperforming ‘value’ holdings, as investors look to companies that can provide higher quality earnings
Argonaut has a basic belief that bull markets rarely repeat. To put it another way – the kinds of stocks that lead one market cycle are unlikely to lead the next.
This is in part because financial markets always over-extrapolate trends and therefore over-allocate capital to booming industries, sowing the seeds of an eventual bust.
This is also true of investment styles; not least the perpetual debate between ‘growth’ investors, who seek stocks with a high return on equity or trade at high valuations as a multiple of their net tangible assets, and ‘value’ investors, who look for stocks with lower returns on equity but cheaper valuations.
The 1990s saw ‘growth’ stocks outperform massively. This reached its apogee in the Nasdaq dotcom-fuelled bubble of 1998-2000. This has been followed by an equally impressive outperformance of ‘value’ stocks from 2000-2008. The explanation of the success of this ‘value’ trade lies not only in the nosebleed 2000 valuations of stocks with a high return on equity, but in the fact that the 2000-2008 period featured robust global economic growth led by the industrialisation of emerging markets and an abundant availability of capital.
‘Value’ stocks are intrinsically weaker businesses, as evidenced by a structurally lower return on shareholders’ equity. This can reflect a company unable to maintain profit margins through the absence of a strong competitive advantage. It can also be symptomatic of a company that consumes too much capital, that can only sustain its profitability by undertaking significant ongoing reinvestment, which in turn requires external funding. Between 2000 and 2008, the inherent disadvantages of ‘value’ stocks mattered less. Many ‘old economy’ businesses – such as steel, natural resources and capital goods – experienced super-normal profitability, in spite of traditionally offering low returns on equity. The ready availability of capital allowed many ‘value’ stocks to artificially inflate returns on equity by borrowing money – in the case of the banks, for example. Every stock could benefit from the abundance of economic growth and available capital. Any stock trading at a premium multiple was commonly considered ‘expensive’ and therefore a ‘bad’ investment. Any stock at a discount was ‘cheap’ and a ‘good’ investment. The commonly held view that some ‘growth’ stocks should be valued at a premium because they were inherently better businesses became an anathema to investors in the 1990s.
Debt markets witnessed a similar reversion to the mean, not least within Europe, where investors demanded low premiums to compensate for the risks of individual countries. It is worth remembering that at the beginning of 2008 lower quality sovereigns like Greece, Spain and Italy could borrow money due back in 10 years at an interest rate of little more than 4 per cent, while higher quality Germany paid 4 per cent and Switzerland 3 per cent. Today Spanish and Italian money costs more than 6 per cent, while Germany pays a little more than 1 per cent and Switzerland 0.5 per cent. The ‘Great Recession’ of 2008 was a watershed in sovereign debt markets, after which risk premiums have ballooned. Indeed yields on shorter term high-quality sovereign debt have recently turned negative. Valuation in sovereign debt markets has become irrelevant.