Long Story Short: Value at a Crossroads

Has the death of Value been greatly exaggerated? Will the factor thrive in the new inflationary regime or struggle to survive from a Fed pivot? Dan Taylor, Chief Investment Officer at Man Numeric, joins the podcast for this bonus episode on what comes next for the Value factor.

Recording date: November 2022

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Peter van Dooijeweert:

Welcome to Trend Setters, the latest season of the podcast, Long Story Short. I'm Peter van Dooijeweert and this series is all about demystifying the world of quantitative trend following strategies. How they work, why they work, and where they might fit in your portfolio. I'm joined today by Dan Taylor, CIO of Man Numeric, who's come today to discuss all things value. Thanks for joining us, Dan.

Dan Taylor:

Good to be here, Peter.

Peter van Dooijeweert:

So you've been in markets since 1999 and you've seen a lot of different markets. And I guess where I want to start is, why does value cause such soul sucking anxiety for so many people? If I talk about size, nobody writes about it. Quality, some people might debate about it. But in value, there just seems to be passion on, "I hate it. I love it." Is it generational? Old school, new school? What is it?

Dan Taylor:

It might be a little old school, new skill, generational. I think there's a lot of investors out there that really identify as value investors and that's the core of their philosophy. It's in many ways, it's an intuitive approach. You're trying to buy an undervalued asset and earn an exceptional return from that. And so it's natural that many investors have adopted that and I think there's been a lot of success among some professional investors going back a hundred years using a value type approach. More recently in particular, when we look over the last decade or not, we've been in a very unique and different world than for much of the last century, where money was free, real interest rates were negative. We had some very persistent growth stories that ended up dominating the market and a lot of value managers ended up struggling during that period. And we've seen sort of post COVID, a bit of a return to normalcy, I'd say, with respect to value investing.

Peter van Dooijeweert:

Yeah, I guess that's interesting, because for the 2010s it really was painful. And I guess one of the examples is Einhorn, who's among the, I guess well known value investors. 2017, he said, "Value is dead." And value has had a pretty good run recently, but he says it's still dead. Any thoughts on that?

Dan Taylor:

Yeah, I don't think value is ever really dead. And it's actually really interesting that he's saying that value is dead in 2022 after a year and a half to two years of outstanding value performance. Back in 2017, it was certainly going through a difficult period and that difficult period continued for a number of years. It continued in fact through the COVID crisis. And I think there were a couple of different contributors to it at that point in time. Certainly the low and declining interest rate environment we were in sort of post global financial crisis, I think contributed to it. You had significant globalization. You had significant technological enhancements and all these things I think came together to create an environment that was fairly robust for growth. Some of these growth companies were able to continue generating excessive profits and grow much longer than you might expect a company to do.

And that sort of slowed down post COVID. We're in a different environment now. We've, over the last 12 months, gone to a much more normal interest rate environment. I mean as crazy as this year feels in terms of the poor asset class performance, a lot of what we're seeing is really paying the price for actually getting back to some semblance of normalcy. And then you put that in combination with potentially the early signs of de-globalization, a reversal of what we've had really for the last couple of decades. And you can see how we could be in a fairly new environment with respect to inflation. And that should be and has been over the last two years anyways, an environment where value has been able to perform much better than it had for much of the prior decade.

Peter van Dooijeweert:

So there's a lot to unpack there, between rates and growth and those sort of things. But I want to put some of the Einhorn comments to bed first, because he mentioned something, the world has moved to be more passive, so there's less competition for what value investors do. But he also says investors are no longer looking at how to value companies. Nobody does the spreadsheets, nobody asks the questions. Whereas in the old days, he could buy a stock and the investor community would wake up to it and then the stock would rally 50%. Now that doesn't happen anymore. Is he just impatient, greedy, or what's going on?

Dan Taylor:

Yeah, I don't know. There's a couple of weird points there. I mean, the fact that I think he's right that people pay less attention to the pricing or the valuation of companies. And some of that is, it has been the increasing popularity of the growth style of investing. I think a lot of that has just been the move towards passive investing where the marginal dollar is essentially indifferent. In fact, almost not indifferent, almost the more expensive something is, the more that marginal dollar will want to buy it. So I think he has a good point in terms of people not looking at it.

I'm not quite sure why he would complain about that though. I think less competition should be a positive from a perspective view of the potential efficacy of value. If there's less people doing it, you may have to be more patient, you may have to wait for the rewards of that to come, but I'm not sure how healthy it'd be to say, "Okay, I'm going to buy the stock. It's cheap. Everybody, David Einhorn, bought the stock and now it's going to go up 25% and I can move on to the next one in three and six months and do it again." I mean, it might require a little patience, but I would think to both value investors and other active investors with different types of strategies, the less competition there is, the more passive there is, the bigger the opportunity there should be for the active investors.

Peter van Dooijeweert:

And so does it turn it into a carry trade or you just got to earn out like the earn the earnings yield?

Dan Taylor:

In a way, I think the value trade is very much a carry trade. I think that's a good way of putting it.

Peter van Dooijeweert:

And if it's a carry trade, then does it suffer from potential shocks? We can talk about a bit more in depth later.

Dan Taylor:

Yeah, it clearly does. I mean when we look at a couple of shocks that we've seen really over the last three decades. I would say the original tech bubble, back in the late '90s, that was a bit of a shock to the system. It was unwarranted, it was irrational and ultimately value made all that back and then some. The global financial crisis was a bit of a different beast. That was a shock and value did not necessarily recover all of the losses that it incurred during that period. And a lot of the cheap companies during the global financial crisis are no longer with us or they're with us in an entirely different structure. And then COVID was a bit of a shock and it actually kind of accelerated or exacerbated what had been going on in the markets really for the couple of years leading up to that. It become an increasingly concentrated pro-growth market in 2018, 2019.

I still didn't think it actually resembled the tech bubble in terms of the extremity of the valuations and the craziness that was going on. But actually, when COVID hit the markets and the markets plummeted and then rallied quite dramatically and growth led both on the way down and the way out. You sitting there in April-May of 2020 and saying, "Okay, this actually now is starting to look a bit crazy." So you do end up with those shocks and in an ideal world, you'd have something that would help buffer those shocks or you'd have the patience to be able to ride them out.

Peter van Dooijeweert:

I guess keeping with that train of thought on growth and how things went after COVID, I always notice as an outsider to value, there's a tendency to try to distill it to something simplistic. And so value is anti-growth. And so your comments on COVID sort of suggest that. Is value anti-growth?

Dan Taylor:

It can be. That's certainly not how we try to implement value at Man Numeric. They're different forms of value and some of them will tend to be either anti-growth or anti-quality. And if you think about a naive value strategy, almost by definition, has to be anti something. There's no free lunch out there. So I'd say typically naive value strategies and maybe the best example that would be a simple price-to-book strategy, is going to be some combination of anti-growth and anti-quality.

That being said, I think more sophisticated value managers, and I'd like to include ourselves in that conversation, attempt to build something that's a bit more robust and controlled for those types of effects. So we're trying to find attractively valued securities and not bet against growth and not bet against quality. So is there a universe of stocks out there that we can acquire that actually do have healthy growth prospects and healthy quality prospects? So again, I think the devil's in the details in terms of how one implements it. Clearly as difficult a stretch as it was for value in the 2010s, the more naive the approach, the more anti-growth it was, the more difficult that would be. Interestingly, over the last two years actually, the more naive approaches have been more effective. That anti-growth exposure that you get from a naive approach has paid off quite handsomely, given what else has gone on in the financial markets over the last two years.

Peter van Dooijeweert:

Yeah, I guess that's a good point. So when you talk about how you look at value on a sector basis or cross sector, there's a difference between being long energy stocks after COVID and short tech, whatever the [inaudible 00:10:02] answer be, as opposed to how you're looking at. I guess maybe you could give us a little insight how you do things differently than them.

Dan Taylor:

Yeah, I mean we tend to focus on relative value approaches and so that's going to be within industries, within sectors, what companies are attractively versus unattractively valued. So for example, a naive approach, may be one that focuses on price-to-book and is not relative, for much of the last decade would be long financials and long energy stocks just because those trade at much lower price-to-books, generally have lower profitability and more complicated balance sheets. And that's been a bet for the last decade, if you were heavily long financials and long energy and short say technology, that'd be a pretty painful trade. Now it'd be fantastic for the last 12 or 18 months, but we tend to focus on identifying attractively value companies. And when I mention how naive approaches can be anti-growth or value, one way, and it doesn't get you all the way there, but one way to control for growth and value is to look at value within industries, because typically different industries have different growth and quality characteristics to begin with.

Peter van Dooijeweert:

So it seems you're saying price-to-book is dead. Is it because the market can't get intangibles right? Is there something different in the narrative versus after this big shock in growth stocks?

Dan Taylor:

So I'd consider price-to-book to be probably the most naive definition of value. And whether or not it's dead or not, it's highly simplistic and it's also, while not totally irrelevant, is certainly less relevant in the New World economy where there's less factories and there's more intellectual property type things that may not show up on the balance sheet as much. So intangibles certainly are a part that's missing from the traditional price-to-book and a lot of people have looked at how, including ourselves, how we can incorporate intangibles into our definition of valuation.

I think I've heard some people argue that actually if you include intangibles, price-to-book has performed reasonably well. I've not seen that. The research I've seen, the research we've done internally, would suggest that, and this is going rewinding not last year and a half, but before that, that price-to-book was a miserable strategy and if you incorporated intangibles, it became like half as miserable. But it wasn't the missing piece. I mean ultimately, companies are going to be valued on profitability, on cash flows. That's what's relevant and book value is a backward looking indicator with a lot of noise to begin with.

Peter van Dooijeweert:

So as a host, I don't really like to be told that my question was incredibly naive. We have other wording for that. Keeping with the distilling of value into some root element. The other argument is yeah, you're basically just biased toward rates going up.

Dan Taylor:

So it's an interesting point and it's a point I've actually made and written a bit about. And that point is that one of the reasons value suffered, is value is essentially a short duration bet, where your long-short duration companies which are cheaper and earning more of their cash flows. And the near term is short, longer duration companies. And so the declining rate environment and in particular negative rates, real rates that we witnessed for a lot of the last five years, that was, I believe, a very difficult setup for value. And actually if we look empirically, you would see over that period of time and up until recently, that you could very easily predict if value was going to work or not in a particular month if you knew what rates were doing. And that relationship was statistically significant and quite persistent for some period of time.

Interestingly, we've seen that start to fall apart over the last six or nine months. And I've seen some claim, and I haven't looked at this explicitly, I'm not sure how statistically significant it would be, some claim that value is a bet on rates when rates are very low. But when rates get to more normal levels or higher than normal levels, that that relationship falls apart. And we've actually seen that a bit in the third quarter this year, where rates continue to rise pretty dramatically. But value actually didn't have a stellar quarter, certainly not compared to what it done over the last several quarters. And I think part of that was concerns over potential hard landing economic recession. We actually saw breakevens come in a bit. So we may be approaching a point where it's not just about rates per se, but future inflation expectations and expectations for future changes in rates.

Peter van Dooijeweert:

So on the inflation side, and then we'll go to deflation in a second. So on the inflation side, if inflation stays persistent, but doesn't run out of control and the Fed doesn't go crazy, is that a better environment for value and still bad for growth?

Dan Taylor:

It should be. It should be. And we have seen somewhat stubborn inflation. We've seen a revaluation in the market of growth stock multiples, and it wasn't that long ago where you'd see growth stock multiples at 40 to 50 and the justification being, well rates are one and half or 2% and real rates are minus 1%. And so 40 or 50 multiple makes sense. On the growth side, we've seen that come down to 25 or 30. And for some of the FANG stocks, actually some of the FANG stocks that still have a healthy multiple, at 20 to 25. Could we see those fall further? Could we see a little bit more compression there? Yeah, I think if the Fed ultimately has to raise rates to four and a half or 5%, you could see some further compression there.

And then on the flip side of that, if economic conditions deteriorate quite quickly and the Fed has to pivot, that could present a bit more of a challenging environment. Both for growth, because I think that might be an environment where it's hard for those companies for growth to grow, but also on the value side of the equation where those companies will tend to be more economically sensitive.

Peter van Dooijeweert:

And without trying to call what the Fed is going to do-

Dan Taylor:

If you know, let me know.

Peter van Dooijeweert:

Yeah, well, I do. Can value survive a Fed pivot? And what I say the Fed hikes and pivots the same day, largely the expectation is equities are going to fly, growth's going to fly. So how's value going to survive that initial shock?

Dan Taylor:

Yeah, I think a Fed pivot would probably be challenging for value, certainly when that occurs and shortly thereafter. It's not really... You would see and there are days here and there, where the market is kind of thinking, "Oh, maybe the Fed's going to pivot." And you can see on those days that it's a bit more challenging for value and that growth stocks end up performing very well. So reevaluating back to an environment that they came to know and love over the last couple of years. So I do think that would be a challenging environment for value.

One of the things we look at internally, is valuation dispersion. And this is essentially the different... How far apart are cheap and expensive stocks? And cheap stocks are obviously always cheaper than more expensive stocks, but the closer those multiples get, the less dispersion there is. And what we saw during the aftermath of the COVID markets, was actually dispersion went basically, to all time highs, depending on how you define it. But in some cases in excess of what we saw during the global financial crisis and close to or on par or more than what we saw during the tech bubble of a little more than 20 years ago.

Now that values perform very well over the last year and a half, we have seen dispersion come in across the regions, but it's still actually at fairly wide levels. So roughly dispersion has come in by about half off of its highs over the last year and a half, two years, but still sits much wider than normal. So that should provide some cushion, should there be a Fed pivot. And actually until the Fed pivot, value should be fairly positioned well to work. Again, the real concern and what would cause the Fed to pivot is going to be increasing evidence of a hard landing coming. And that again, would probably be difficult for value and that's where you hope you might have other insights like trend, like quality, that are better positioned for some kind of Fed pivot.

Peter van Dooijeweert:

You brought up dispersion and value, a bit at a valuation basis, but what about regionally? Europe looks incredibly cheap on a multiple basis. EM value seems to have been hit hard as of late. The US is a huge percentage, 70% of the global MSCI All World Index. What does it look like regionally?

Dan Taylor:

Yeah, so when we look at dispersion, we try to disentangle it from the level of valuations in the market. And as you say, Europe is extremely cheap. Japan, emerging markets, are cheap. The US by its own standards is cheap. And of course the big question there is what's going to happen to forward earnings, particularly if we go into recession. But we talk about dispersion, it's basically trying to hold the level of market valuation constant. And so what we see geographically actually right now, is that emerging markets is where the dispersion is the widest, relative to its own history. In Japan, actually, the dispersion is the narrowest, relative to its own history. And then in the US and Europe, it's still in a very healthy place, but not as wide as it was a year or two ago.

Peter van Dooijeweert:

And you've brought up deflationary shocks, pivots, there seem to be plenty of ways to have some short-term challenges. How do allocators deal with that? Should they just think of it as a long-term strategy, buy and hold and earn it out? Or what's the way for an allocator to think about the problem?

Dan Taylor:

Timing is very, very difficult for these sorts of strategies. I think you have to be diversified. This may be the only free lunch in capital markets, is diversification. I think you do have to be a long-term holder, but if you can opportunistically identify times where you might want more or less, that would obviously be valuable. I think the easy money has probably been made with respect to the value trade. And what I mean by that is the above average opportunity that presented itself following the COVID crisis, that has, about half of that, has corrected and I would call that the easy money. There should be more to go, but it is important to have a diversified strategy.

And if your worldview is one of, with the events that are going on in the UK capital markets recently, if your worldview is one that actually the next year or two is going to look somewhat like the global financial crisis, how that played out in 2008, you probably don't actually want that much exposure to value. You'd probably be looking more at defensive quality trend, maybe growth and value would not want to be. But if your worldview isn't that we're heading towards that kind of global, near depression scenario, then I think it makes sense to have exposure to that. But you do have to be, I think, diversified across various different strategies.

Peter van Dooijeweert:

Yeah, I think that's the one thing we learned this year. There's just no way to guess what's coming next. I mean, people have tried to call the bottom 15 times. They've called the peak of inflation 20 times and I think it's time to just give up on that. And in that sense, if value behaves a little bit like carry, it's something that you can have and not get so fussed I think with particular mark-to-markets, although that's incredibly easy to say. So while we've got you here, besides value, Numeric does other things. And so maybe just talking about some of the other factors. Value has clearly bled into the Momentum factor. Why is that happening? Because I bet a good chunk of the investing population thinks that Momentum equals growth.

Dan Taylor:

Which is a pretty poor assumption, quite frankly. There are times and certainly during the late 2010s and into COVID, where Momentum and growth were synonymous, but they have diverged quite significantly over the last year or two in particular. And Momentum, the way we look at a cross-sectional Momentum, is generally very diversifying to value exposure. And we've even seen that over the course of this year, where in the third quarter for example, when value struggled a bit, it wasn't actually that bad, but certainly was not as productive as it was over the prior three quarters. Momentum actually worked quite well and a lot of the trends that have, the new trends, that have been playing out, there's been a lot of auto correlation there we've seen in Europe and we've seen in the US. So a trend is definitely something cross-sectional Momentum that helps to offset value exposure.

And today, it's quite orthogonal to growth. I mean growth is a factor that we look at. We implement in a few places but is not a core attribute to most of our strategies. We find historically that the market overpays for growth and that there's not really alpha associated with that. There may be other ways to slice it that we're not doing. Certainly there's a number of successful growth managers that are out there. That being said, the naive approach to growth worked incredibly well up until say mid, late 2020 and has been incredibly painful, I think, for those that have been doing that over the last year.

Peter van Dooijeweert:

Is growth cheap?

Dan Taylor:

That's a good question and honestly I think quality growth probably is cheap right now. We've seen, I mean I mentioned some of the revaluation we've seen in the market and looking at for some popular growth stocks, multiples going from 40 to 50 to 20 to 30. And I do think if you look at the universe of quality growth companies out there, is it pound the table cheap? I don't think I would say that, but I think it's cheap. And the risk there, is almost the opposite of the risk for value right now. The risk there is that inflation remains stubborn, the Fed has to continue to raise rates and you suffer further multiple compression. I mean that is a possibility.

But there is a universe of securities out there that still have pretty decent organic growth characteristics, have fairly attractive free cashflow yields and haven't traded at multiples like this for some period of time. So I suppose the weird thing about paying a 40 or 50 multiple for a company, you can justify it when rates are zero. If you make the assumption that rates will be zero for a long period of time, that assumption at least hasn't played out over the last couple of years. And so there's still going to be some sensitivity to future rate changes there. But actually quality growth, I think is a very interesting part of the market right now.

Peter van Dooijeweert:

Maybe I'll just finish our conversation with one last question. In some of our other podcasts recently, we've just been asking people, "What are the big risks to investors kind of looking for?" We've touched on a little bit in terms of a deflationary shock, but just kind of your worldview over the next kind of six, 12 months.

Dan Taylor:

So I think that a couple of the risk I would highlight. One, there's not really a lot of diversification in global equity markets these days. The US is 70% of MSCI World, 65-ish percent of MSCI ACWI. That's a very high number. It's as high as it's ever been. Essentially global equity markets are a bet on the US companies. And some of the companies are global companies. So there's some sense there. So I think that's one big risk. And if I were allocating, I'd be thinking significantly about regional diversification and the fact that, for better or worse, Europe, China, Japan are all in very unique situations relative to each other, as well as relative to the US. And so I'm not sure that MSCI World is as diversified as it could be. And so I think there could be a little bit of a free lunch there. If you're not of the worldview that the US will continue to be exceptional and dominate and that's a debate in and of itself. So I think that's one big risk.

The other big risk I would look at right now, and maybe we've seen a bit of the tip of the iceberg in the UK, is how we get back to normal in the way that the capital markets can absorb. And in particular, if we look at the rising rates that we are witnessing to help dampen inflation, how do the governments with increasing debt loads roll over that debt, sustain that debt? We're talking about in the US, I don't have the exact numbers off of the top of my head, but interest payments on the debt in the US going from a fairly small and modest number to potentially a much more significant number going forward. And my actual guess is that we'll probably have to live with some sort of steady state inflation that's a bit higher than certainly what we've been used to in the past.

And the Federal Reserve and other central banks are going to be trying to thread the needle and find where is the sweet spot between getting inflation kind of under control, like not 5, 8, 10, 12%, but realistically maybe not getting to 2% either, because it's not clear that the global economy could function in a healthy aspect if we tighten the reins enough to get back there. So that's a big risk.

I think people talk about policy errors right now and is the Fed making a policy error? I think it's clear that probably globally central banks made a policy or a lot of the central banks made a policy error around COVID in terms of, and actually for a lot of the last decade, in terms of free and easy money trying to, the goal of economics, to smooth out these realizations over time. And it's sort of always easy to borrow from the future to help smooth things out today, but at some point, you have to pay the piper. And it feels like we're at the tip of the iceberg here in terms of potentially doing that. And that has a lot of ramifications across asset classes and certainly there's some opportunities there, but I think presents a major risk as well to investors.

Peter van Dooijeweert:

Yeah, I think that's it. The Central Bank spent 10 years getting people to buy things, whether it's pensions to buy gilts in the UK or the US to just buy assets. Now then when they want you to sell them, there isn't necessarily the buyer of last resort as there might have been in the past. Well, it's been a great chat. Thanks for coming on.

Dan Taylor:

Yeah, thanks for having me.