The end of the value trade may be near as investors push prices beyond economic growth expectations.
Interestingly, it was just last year that I wrote: “The Rotation to Value Is Inevitable.” The critical point of that article was this:
“The market’s surge higher since the financial crisis, which has been driven by massive fiscal and monetary policies. It has been nothing short of extraordinary. Currently, the S&P 500 is trading at the greatest deviation from its long-term exponential growth trend in history.”
The unparalleled monetary policy use to push markets higher, massive fiscal spending designed to keep economic growth positive, and corporations shunning future growth for “share repurchases” remains the common thread.
As Michael Lebowitz, CFA, previously noted:
“As a result of these behaviors and actions, we have witnessed an anomaly that historically spelled success for investors. Stronger companies with predictable income generation and solid balance sheets have grossly underperformed those with unreliable earnings and over-burdened balance sheets. The prospect of majestic future growth has trumped dependable growth. Companies with little to no income and massive debts have been the winners.”
Such was much the same as we saw in late 1999 as companies with no earnings, no revenue, and no real strategy for growth exploded higher in a speculation-fueled buying frenzy.
Is It The “Great Rotation?”
Since the end of last year, the “value” rotation finally did get underway, with the energy sector leading the charge. Industrials, Materials, and Financials joined the advance as expectations for “infrastructure spending,” and “reopening” grew. The chart below shows sector performance relative to the S&P 500 index over the last 120-days.
Historically, when rotations to “value” have occurred, it has accompanied significant market reversions and a break of the previous “bullish” psychology. The accompanying destruction of capital pushed investors into requiring a “margin of safety.”
Such was not the case this time as investors chasing “growth” rotated to pursue the market’s laggards. In other words, as I noted this past weekend:
“With the ‘value trade’ excessively overbought and has become the recent ‘momentum’ trade, we may see a relatively rapid rotation back into recently beaten-up sectors.”
As shown below, the performance between “growth” and “value” has now inverted.
The question that we must answer is whether the rotation is sustainable in the future.
Value in Name Only
Ben Graham heavily espoused the importance of a “margin of safety” in the investment operation. The margin of safety suggests an investor only purchases securities when their market price is significantly below their intrinsic value.
Followers of Ben Graham’s teachings have a deep history of long-term investing success, from Warren Buffett to Seth Klarman:
“The best investments have a considerable margin of safety. This is Benjamin Graham’s concept of buying at a sufficient discount that even bad luck or the vicissitudes of the business cycle won’t derail an investment.” – Seth Klarman
The problem with the current “value” trade is there is very little, if any, “margin of safety” in the company’s investors are piling into. As discussed in “The Astonishing Lack of Value:”
The chart is pretty stunning but needs some explanation.
Theoretically, book value represents the total amount a company is worth under a liquidation scenario. Such is the amount that the company’s creditors can expect to receive.
Book value analysis and buying companies with low “price-to-book” ratios have historically been profitable ventures. Companies with machinery, inventory, and equipment, and financial assets tend to have large book values. Significantly, these types of investments are easily valued and liquidated in the event of financial stress or bankruptcy.
However, today, as shown, such is no longer the case. With the rise in gaming, software, database, consultancies, etc., the increase in “intangible assets” has surged. Items such as patents, licenses, human capital, etc., now make up a significant portion of many company’s “value.”
These types of assets are hard to value and more difficult to liquidate. Such is especially the case with human capital or a measure of an employee’s skill set’s economic value.
The Evolution of Intangibles
“Intangibles used to play a much smaller role than they do now, with physical assets comprising the majority of value for most enterprise companies. However, an increasingly competitive and digital economy has placed the focus on things like intellectual property, as companies race to out-innovate one another.
To measure this historical shift, Aon and the Ponemon Institute analyzed the value of intangible and tangible assets over nearly four and a half decades on the S&P 500. Here’s how they stack up:” – Visual Capitalist
“In just 43 years, intangibles have evolved from a supporting asset into a major consideration for investors – today, they make up 84% of all enterprise value on the S&P 500, a massive increase from just 17% in 1975.
Digital-centric sectors, such as internet & software and technology & IT, are heavily reliant on intangible assets. Brand Finance, which produces an annual ranking of companies based on intangible value, has companies in these sectors taking the top five spots on the 2019 edition of their report.” – Visual Capitalist
While the issues of “intangibles” should undoubtedly be a concern for “value” investors, another issue further compounding the problem. Debt and accounting gimmicks.
A Compounded Problem
As discussed previously in “EBITDA Is Bull****,“ the heavy use of accounting gimmicks is obfuscating publicly-traded companies’ actual value. As noted:
“An in-depth study by Audit Analytics revealed that 97% of companies in the S&P 500 used non-GAAP financials in 2017, up from 59% in 1996, while the average number of different non-GAAP metrics used per filing rose from 2.35 to 7.45 over two decades.
This growing divergence between the earnings calculated according to accepted accounting principles, and the ‘earnings’ touted in press releases and analyst research reports, has put investors at a disadvantage of understanding exactly what they are paying for.”
Compounding the problem of accounting issues is surging corporate debt levels, and the issue becomes more apparent. Given the Federal Reserve’s monetary injections and suppression of interest rates, companies heavily leveraged their balance sheets. As interest rates plunged, corporations issued a record amount of debt to pay dividends and increase share repurchases.