Dear Clients and Friends,
Recent pronouncements by the U.S. Federal Reserve and European Central Bank imply that "lower for longer" is likely an ongoing reality for interest rates in the United States and European Union.
For many, this macro environment is perceived to present an insurmountable challenge for value investors. Several recent articles have suggested the possible demise of value investing because, among a number of factors, lower interest rates should inherently favor growth stocks. Value investing--these doomsayers claim--may no longer work in a persistent low-interest rate environment.
We agree that "lower for longer"--some refer to this as "Japanization" because interest rates have been very low for nearly 30 years--seems plausible, if not likely. The process of adjusting to meaningfully lower interest rates (and cost of capital for businesses) since the financial crisis has made it particularly difficult for value investing for much of the last decade. However, as a bottom-up, fundamental investor, we don't believe we can predict the path of interest rates. As Exhibit 1 shows, not many others can either: consensus and sentiment can change quickly. While the largely shared view today is that interest rates will likely continue to decline, only nine months ago many market observers predicted U.S. interest rates would rise.
Exhibit 1: Fed Funds Futures Probability
In this case, the largely held view proved correct. On the final day of July, the Federal Reserve reversed course and for the first time since the financial crisis of 2008-09, it lowered the target range for the benchmark rate by a quarter-percentage point to 2% from 2.25%. It also hinted that it may cut the rate again to shield the U.S. economy from global growth that has been losing steam.1
This development simply illustrates the challenge of predicting interest rate paths and ultimately, the futility of trying to do so.
Despite the Fed's reversal, low interest rates may not persist forever--and that is one reason why we believe it is prudent to consider owning at least some component of the "value" portion of global equity markets. The wide performance and valuation divergence of companies and sectors that we are seeing suggests that many are throwing in the towel on lower-growth companies with sound fundamentals, despite highly attractive valuations. Evidence of the shift that has occurred in the wake of a challenging decade for low-valuation equities appeared in a recent Wall Street Journal article, "Want to Invest in a True 'Value' Fund? Good Luck Finding One." Its headline suggested that finding a true value fund is very difficult because many one-time value-focused managers have become susceptible to style drift. How value investing will perform in the future is hotly debated, but we believe lessons from the past may be instructive in how this debate is ultimately resolved.
Value Investing Is Ready for Its Next Act--Not Its Obituary
The market environment we find ourselves in today is in many ways extremely reminiscent of the one we experienced 20 years ago. In 1999--and into early 2000--there were numerous pundits proclaiming the "death of value" as an investment style. The underperformance of value indices had reached unprecedented levels. The belief then was that faster growing companies (primarily in technology-related sectors) would overwhelm "old economy" companies making up the vast majority of the market.
And that brings us to today. While the companies and sectors have changed slightly, it appears the behavioral tendencies of the late '90s that led to wide performance and valuation dispersions have caused a similar imbalance in today's market environment. As Marko Kolanovic and Bram Kaplan of J.P. Morgan recently wrote, "...there is a record divergence between value/cyclical stocks on one side, and low volatility/defensive stocks on the other side. The level of divergence is much more significant even when compared to the dot com bubble valuations of the late '90s."2
The skeptics of value stocks were as loud as ever in the late '90s; however, the subsequent performance told a very different story. For the next 3 years (from March 2000 to 2003) the value portion of the market (represented by the MSCI World Value Index) outperformed the MSCI World Growth Index by 11.3% on a compounded annual return basis.3 Importantly, this outperformance came during a period of dramatically declining interest rates with the effective federal funds rate declining from 6.5% in October 2000 to under 1% at the end of 2003.4
While Japan has experienced persistently low interest rates over the past two decades, during this long stretch of time, value has had periods when it has outpaced the market .5 In other words, sharply declining interest rates didn't preordain a period of long-term value underperformance, probably because the starting point was a period of extreme valuation divergence. Despite similar, and in some cases wider, valuation dispersions today, we don't believe future interest rates--even if the U.S. and Europe follow Japan's path--will predetermine relative performance down the road.6
Wall Street Journal: Good Luck Finding a 'True' Value Fund
As mentioned, the Wall Street Journal ran an article about the difficulty of finding a genuine value manager with the headline: "Want to Invest in a True 'Value' Fund? Good Luck Finding One."7 The story reported that many traditional value managers have been prone to style drift to contend with an exceptionally difficult environment. Various explanations have been offered for this behavior and new terminology--"nuanced value"--has entered the investing lexicon. This language describes the tendency of some managers to "pay up" for quality or to justify adding growth stocks to their portfolios.
We will not second guess these managers, as many have correctly navigated the trends of the recent past. However, we do think investors should understand how their portfolios are positioned and whether they are likely to participate if/when there is a recovery in the value cycle. As a truly consistent and committed value manager, Brandes sees those who have drifted away from a true value offering as "VINO managers," that is: Value-in-Name-Only. By contrast, we have resisted following the herd and compromising our disciplined value selection criteria. While they're not always winning short-term popularity contests, we believe our portfolios continue to display very attractive valuation characteristics.
No one knows precisely when the cycle may turn, but there is a chance that we are nearing an all-time low point for value investing. Many pundits are convinced value will continue to struggle, while a few are beginning to think we may be at a promising entry point for true value.
We thank you for your continued business and loyalty to Brandes.
1 CNN Business, Markets Now: "The Fed cut rates for the first time since 2008." Donna Borak, Updated 5:14 PM ET, Wed. July 31, 2019,https://www.cnn.com/2019/07/31/business/fed-rate-cut-july-meeting/index.html.
2 JP Morgan, Global Quantitative & Derivatives Strategy: Market and Volatility Commentary, Largest divergence ever presents opportunity for Value and High Volatility stocks, Marko Kolanovic, PhD, Bram Kaplan, CFA, July 16, 2019, p. 2.
3 Source: MSCI via FactSet. Results for Feb. 29, 2000 to Feb. 28, 2003 in US$. Rolling Multi-Horizon: Annualized Return. MSCI World Value Index - Net Return of -10.86% vs. MSCI World Growth Index - Net Return of -22.14% for a difference of 11.3% on a compounded annual return basis.
4 Federal Reserve Economic Data, Economic Research Division, Federal Reserve Bank of St. Louis, Effective Federal Funds Rate, Percent, Monthly, Not Seasonally Adjusted. https://fred.stlouisfed.org.
5 Source: Brandes, MSCI via FactSet, Ken French Database. For the 20-years ending June 30, 2019, the MSCI Japan Value Index outperformed MSCI Japan Index on a rolling return basis at different points during the last 20 years and for the entire period. Brandes also used Ken French's returns database for Japan which shows the outperformance of high minus low (HML) book-to-price for 1991 to 2018 and determined there were significant periods of value outperformance during the past 30 years; the favorable difference on average was 2.64.
6 Source: MSCI via FactSet. Based on the Price-to-Book valuation dispersion between MSCI Japan Value Index and MSCI Japan Growth Index for the period from Dec. 31, 1975 to June 28, 2019 (Quarterly). The value discount to growth ranged from a low of 32% in June 2009 to 74% in March 1987. For the last period analyzed, June 2019, the value discount to growth was 61%.
7 Published February 3, 2019, https://www.wsj.com/articles/want-to-invest-in-a-true-value-fund-good-luck-finding-one-11549249860.
Past performance is not a guarantee of future results. One cannot invest directly in an index.
Price-to-Book: Price per share divided by book value per share.
Rolling periods represent a series of overlapping, smaller time periods within a single, longer-term time period. For example, over a 20-year period, there is one 20-year rolling period, eleven 10-year rolling periods, sixteen 5-year rolling periods, and so forth.
The MSCI World Growth Index with gross dividends captures large and mid cap securities across developed market countries exhibiting growth style characteristics, defined using long-term forward earnings per share (EPS) growth rate, short-term forward EPS growth rate, current internal growth rate, long-term historical EPS growth trend, and long-term historical sales per share growth trend.
The MSCI World Value Index with gross dividends captures large and mid cap securities across developed market countries exhibiting value style characteristics, defined using book value to price, 12-month forward earnings to price, and dividend yield.
The MSCI Japan Index with net dividends is designed to measure the performance of large and mid cap segments of the Japan market.
The MSCI Japan Value Index captures large and mid cap Japanese securities exhibiting overall value style characteristics. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.
The MSCI Japan Growth Index captures large and mid cap securities exhibiting overall growth style characteristics in Japan. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.
This material is intended for informational purposes only. The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings, or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Strategies discussed herein are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. The Brandes investment approach tends to result in portfolios that are materially different than their benchmarks with regard to characteristics such as risk, volatility, diversification, and concentration. Market conditions may impact performance. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes, differences in financial reporting standards and less stringent regulation of securities markets which may result in greater share price volatility.
The foregoing reflects the thoughts and opinions of Brandes Investment Partners(R) exclusively and is subject to change without notice.
Brandes Investment Partners(R) is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.
This article first appeared on GuruFocus.
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