I've been talking a lot to Charlie Morris, investment director of The Fleet Street Letter, this week. Charlie wrote a great MoneyWeek magazine cover story for us on what he sees as being one of the biggest investment themes of the year – the shift from growth to value.
In essence, it means the stuff that the market has been chasing higher – like FANG tech stocks (Facebook, Amazon, Netflix and Google) for example – is vulnerable, while the stuff that the market has held in contempt (such as mining stocks) is making a comeback.
I wanted to expand a little bit more on this, because I agree that it could be one of the most important themes of this year – and maybe beyond...
Why does value investing make sense?
Ben Graham – the father of value investing and mentor to Warren Buffett – had a famous metaphor to explain the value investing process. He noted that Mr Market's desire to buy or sell on a given day didn't necessarily have anything to do with "reality".
So if Mr Market was in a good mood, he'd pay more than an asset was "worth". And if he was feeling jittery, he'd sell it at bargain prices. The asset itself didn't change. Just Mr Market's disposition.
Of course, this makes a mockery of the efficient market hypothesis (EMH) – the idea that all information is priced in at all times, and that market participants are perfectly rational (judged by a very narrow set of parameters). But most people outside of academia would happily admit that EMH is at best a guideline.
Anyway, countless studies have proved Graham right. One point, examined by Nobel Prize winner Robert Shiller, among others, is that share prices are far more volatile than changes in dividends or earnings would justify. In other words, price movements tend to exaggerate the underlying "rational" data – the market has mood swings, as the metaphorically-inclined might argue.
This means that it really is possible for assets to be "cheap" or "expensive" relative to fundamentals, which means that if you buy cheap, one day you'll be able to sell "expensive".
Ben Inker, one of the analysts at GMO, explains it very well in more scientific terms. "The basic driver for long-term value working historically has been the excessive volatility of asset prices relative to their underlying fundamental cash flows."
This means that "outperforming the markets given that pattern requires either betting that the excessive swings will reverse over time" – in other words, that prices will "revert to the mean" – "or accurately predicting what those excessive swings will be" (ie, being able to guess when certain sectors will go in and out of favour, and betting accordingly).
I'm sure you can already see that for a long-term investor one of these options is a lot easier than the other. But in case you don't get it yet, here's Inker again: "The former strategy amounts to long-term value-based investing, while the latter requires out-predicting others as to both what surprises will hit the markets and how the markets will react to them".
This makes so much sense. It's elegant, it exploits a fundamental flaw in our understanding of markets, and it should lead to relatively painless choices for a long-term investor: buy what's cheap, and sell what's expensive.
There's just one snag: it hasn't worked for quite some time.
Value investing just hasn't been working
As Inker points out: "it's no secret that the last half decade has been a rough one for value-based asset allocation". Put simply, in recent years, you'd have been better off buying expensive stuff than cheap stuff. Expensive US stocks have beaten cheap emerging markets, for example.
So what gives? Is value investing broken?
Probably not. Half a decade might be a long time in asset management when you're competing for fickle private client money, but it's not much time in the context of a long-term portfolio. And as Inker points out, this is not the first time that value has underperformed for a prolonged period of time. A similar thing happened during the tech bubble.
The irritating reality for a value investor is that anyone who's good at it is always going to be poking about in the least-loved parts of the market. They'll almost certainly be fully invested in stuff that has a recent history of going down, while their portfolios will be devoid of stuff that has been going up.
That makes you a market pariah, particularly if you're managing money. As Inker puts it: "Your best opportunities will almost always come just at the time your clients are least interested in hearing from you, and might possibly come at the times when you are most likely to be doubting yourself".
The good news, of course, is that you probably don't manage anyone else's money. You just run your own. So the only difficult client conversations you need to have are with yourself.
More to the point, Charlie's spotted something in the charts that makes him think that the big growth to value shift is happening. That's what you can read all about in MoneyWeek magazine this week. But if you're looking for more details on Charlie's thoughts, then check out The Fleet Street Letter.