European equities: Can value close the gap to growth in 2016?
At the recent Schroders Investment Conference in London, our panel of European equities fund managers debated the prospects for growth and value investing in 2016.
Europe’s slow recovery continues
Rory Bateman highlighted the relatively benign economic environment in Europe as the slow recovery continues.
In his view the region is “a supertanker and is now pointing in the right direction”.
The services sector in particular is “looking very encouraging” while, on the corporate profits front, the margin differential between US and European equities is now beginning to close.
“Europe is still an attractive place to invest,” Bateman said. However, within Europe there has been a significant divergence between the performance of the growth and value segments of the market.
Value has underperformed growth for the longest period on record and valuation levels between the two different style groups have also diverged significantly.1
Chart 1: Ten-year annualised relative return of value vs growth
Source: Thomson DataStream, as at 31 December 2015.
Stock-specifics should override style
Making the case for growth investing, Leon Howard-Spink acknowledged that the quality and growth styles of investment enjoyed a tailwind in 2015.
However, he pointed out that stock-specific factors are still the main determinant of fund performance.
This was a point picked up by value investor Jamie Lowry, for whom style trends in the market were a headwind in 2015.
He said that, whatever the style, “what matters more than anything is stockpicking”.
Lowry added that value investing is not simply about buying cheap stocks but instead “looking for low expectations, so that it’s very unlikely that you are disappointed and, if anything positive does happen, you get strong outperformance in the upside”.
Even in a market like 2015, when value overall underperformed, it is possible to find such opportunities at stock level.
Advocating a blend approach to investing, Nicholette MacDonald-Brown pointed out that the style-agnostic can pick the best of both growth and value.
Concurring with the view that stock-specific factors make the crucial difference, she highlighted the importance of looking for individual stocks that are mispriced by the market and that are “in control of their own destinies”, rather than relying on the vagaries of the economic or market environment.
How to spot real value
Howard-Spink pointed out that many of the typical value sectors in the current European context are cheap for good reason.
In his view, “oil, mining, financials, utilities – in 2015 these didn’t represent real value as in most cases their earnings have been poor so the downgrades have been justified”.
He cautioned that investors should not mistake low price-to-earnings ratios for value.
Chart 2: Cyclically-adjusted price-to-earnings ratio
Source: Thomson DataStream, Schroders, as at 31 December 2015. The cyclically-adjusted price to earnings ratio is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation.
Furthermore, Howard-Spink added that some value sectors are “low return, dying industries” and argued that it is better to own a portfolio that is exposed to future growth areas, citing “innovation, changes in consumer behaviour, or changes in manufacturing technology”.
Lowry, however, argued that the history of value investing shows this may not necessarily be the case.
He pointed to the example of tobacco stocks in 2000, when the sector was very cheap but seen as being in terminal decline amid litigation and health concerns.
Tobacco then went on to perform extremely strongly over the next ten years. “You can make good money out of declining industries as long as the share price is low enough [when you buy]”, he said.
MacDonald-Brown highlighted the importance of good and bad deflation when looking at current potential investment opportunities.
Commodity-sellers may look cheaply valued but deflation is bad for them. By contrast, consumer-facing firms have enjoyed “the lovely combination of pricing power and deflation on the input side, which has led to accelerating earnings growth”.
Lowry added that the key to avoiding value traps is to look out for those companies that have appropriate balance sheets as this shows they have the “capacity to suffer”.
Many cheaply-valued companies have the potential to deliver strong returns in the future, but if they go bankrupt in the meantime then clearly the investment case comes to nought.
He noted that many mining firms in particular are “borrowed to the hilt” and said he therefore remains cautious on the sector overall.
The case for growth
Amid a slow global growth environment, Howard-Spink made the point that an individual company’s growth needn’t depend on broad factors such as economic or population growth.
He highlighted the importance of seeking out those companies that have products strong enough to gain market share and that are sensibly managed.
He said that “growth often comes down to innovation”. Capital goods firms can innovate via new methods of production or a new retail concept can be rolled out.
He added that growth is “the gift that keeps giving, via compounding”.
Where are the best opportunities?
MacDonald-Brown took the view that there are possibly more opportunities currently in value, citing a Greek telecoms group and UK supermarket as interesting.
She said the important thing is to look for “an inflection point where value can be realised”.
At the same time, she added that certain growth companies continue to look attractive due to stock-specific factors.
Looking at globally-exposed firms, she acknowledged the market’s worries over emerging market-exposed stocks but noted that “there will be opportunities when people think emerging markets will shrink forever”.
Lowry added that the recent market volatility is not a concern and that such an environment can open up opportunities for all active managers.
He noted that the increase of flows into passive funds means money is being put into the largest stocks, leaving a huge gap in the market for value investors.
Audience poll results
Attendees were asked at the start of the session whether they favoured growth, value or a blend style of investing for 2016, with roughly even numbers selecting value and blend.
The vote was taken again at the conclusion of the session and saw value win the day with 51% of respondents picking it as their preferred strategy for 2016.
1. Growth stocks are those with high rates of growth, both current and projected forward, while value stocks are those that have been under-priced by the market and have the potential to rise in value. ↩