In the US market, over 90 years of evidence shows value investing has perennially been a winning strategy, and one that can comfortably be relied upon over the long term. Unfortunately, for those with a value orientation, that has not been the case globally for over 10 years now, according to MSCI indices. This is an unprecedented length of time. Periods in which growth outperforms have typically been much shorter, including the 3 years at the end of the 1990’s that saw the TMT bubble inflate. That was obviously an extreme period in markets, so the inevitable mean reversion meant value subsequently outperformed very strongly for several years. So the question now, of course, is how much longer will the current malaise last? This is difficult to answer with pinpoint accuracy. But, for those with a contrarian mindset, we think there is cause for optimism.
The dominant force in markets in recent years has been the ascendancy of both US equities and the US Dollar. Following the financial crisis, these assets were merely considered the best house on a bad block, but subsequently have become the destination of choice for global capital. One research house recently observed that over $23 trillion of capital has been invested in US financial assets since 2008. The perception that US assets have stronger, and more secure, growth prospects in an otherwise lacklustre economic cycle has been the driving force behind this safe-haven status.
As a result, and in the context of the last nearly 50 years, US equities have achieved a record level of relative performance compared with non-US equities. To convey exactly how far the elastic is stretched today, we have gone beyond the level achieved by US markets during the heights of the TMT bubble and the prior peak in the early 1970’s. In an economic cycle distinctly lacking in growth, the US has once again become the pre-eminent market globally for growth investing. This leadership is made clear by the following chart.
MSCI USA relative to MSCI World ex USA, total return
Relative valuations reflect this. US equities now trade at a relative premium, measured in price-to-book multiples, of over 1.8x - a level only exceeded once in the last 40 years (the final few months of 1998 and the end of 1999). Value stocks outside the US appear even more unloved, with US equities trading at a price to book multiple 2.5x higher than this group. In fact, the dichotomy became so great last summer that even growth stocks outside of the US briefly traded at a discount to US value stocks, based on earnings multiples. This was a state of affairs unprecedented outside of the recessions associated with the collapse of the Nasdaq and the financial crisis.
MSCI World Value ex USA, relative to MSCI USA, total return
From a shorter-term perspective, the situation also appears encouraging. Countries that typify the value style of investing right now, such as France, Spain, Italy and even Greece are all showing recent outperformance relative to the US. Breadth in the US market, led by a small coterie of high growth (and very large) stocks, has been weakening. And finally, the US Dollar has for most of 2017 been struggling to maintain its positive trend of the last several years, suggesting capital flows are possibly starting to wane or even reverse.
Value investing has been out of favour for so long, many are starting to doubt whether it will ever work again. Indeed, expensive assets can easily continue appreciating and valuation alone is not a reason for a change in the primary trend. But, as Howard Marks observes in his book The Most Important Thing, the goal ‘isn’t to find good assets, but good buys.’ Finding a group of assets that is as cheap as it has ever been relative to another group of assets is a promising starting point for a ‘good buy,’ and value stocks outside the US look deeply depressed in relative terms. After all, once a piece of elastic has been stretched to its historic limits, one outcome is more likely than any other; it snaps back.