The relative merits of different investment styles have been long debated. Today ‘growth’ managers seem to be in the lead, as the market favours growth shares over ‘value’. We believe, however, that these categorisations are too simplistic in terms of how they are typically implemented. Instead, we focus on valuing individual businesses and buying them when they are undervalued. This is certainly a value-oriented approach, but one that is more concerned with valuation versus price, rather than how a stock is categorised.
The standard definitions of ‘value’ and ‘growth’ typically refer to some process of categorising stocks based on simple, point-in-time metrics. For example, this categorisation is often used to:
- Create value/growth indices
- Construct funds based on these indices (e.g. a value/growth ETF, or a smart beta fund focusing on style)
- Construct the funds of some active managers
- Categorise stocks/funds in various applications.
At Allan Gray and Orbis we do not apply this ‘screen, rank, and allocate’ approach based on these simple metrics. This is because the fundamental measure used in these metrics (e.g. the Earnings in the P/E ratio) is just a basic, point-in-time number. This number may not be at all representative of future earnings.
We will consider buying companies when current margins and earnings are cyclically depressed, or even negative. The prevailing P/E ratio may be high, or alternatively negative, and therefore meaningless with respect to the next five to ten years. However, it is the long-term future earnings that matter – and taking a contrarian approach allows us to pay a lower price for these future earnings.
We believe that valuation metrics are important, but we use our own internal analysis of the company to assess the likely range of outcomes through the full cycle. We look at long-term fundamentals, which are often markedly different from the current, point-in-time metrics used for indices/style categorisation. We are less concerned with categorising ‘value versus growth’, and instead we focus on ‘valuation versus price’.
Looking at the numbers
The two graphs below show the importance of stock picking over the long term and clearly demonstrate that it is not investing solely in ‘value’ or ‘growth’ stocks that drives outperformance.
Graph 1 shows the annualised performance of the Allan Gray Australia Equity Fund (Class A), versus the MSCI Australia Value Index, the MSCI Australia Growth Index and the MSCI Australia Index over the last twelve years (the Allan Gray Australia Equity Fund was launched in May 2006). As you can see, while the growth index has slightly outperformed both the value index and the broad index, there is not an enormous difference in performance.
Graph 1: Net annualised performance in AUD of the Allan Gray Australia Equity Fund, versus Australian value, growth and broad indices – 12 years to 31 July 2018
Source: Morningstar, 1 August 2006 to 31 July 2018
This is similar in Graph 2, which shows the Orbis Global Equity Strategy versus the MSCI World Value, MSCI World Growth and the MSCI World indices over 28 years. Here you can see that the difference in annualised performance between the three indices is very small over this longer period.
Graph 2: Net annualised performance in AUD of the Orbis Global Equity Strategy, versus world value, growth and broad indices – 28 years to 31 July 2018
Source: Morningstar and Orbis, 1 August 1990 to 31 July 2018. The Strategy’s net returns for the period are illustrative and based on the combined returns of all Orbis global equity funds using the retail fee applicable to Orbis’ Global Equity Fund in Australia. The Strategy is offered in Australia through the Orbis Global Equity Fund (Australia Registered).
In both cases, Allan Gray and Orbis have significantly outperformed all the indices.
Buying cheaply is paramount
We describe our approach as ‘contrarian’. We may buy a stock that the market categorises as growth if it is cheap based on our assessment of its fundamentals. Equally, we may shun a stock the market categorises as value if it looks expensive based on our assessment of its fundamentals.
We are obsessed with understanding fundamental measures, such as earnings, and what we pay for them. The fundamental measure we focus on, however, is our own assessment of future, through-the-cycle normalised/average earnings, rather than a point-in-time measure, such as trailing 12 months or consensus estimates for the next 12 months.
This is consistent with our contrarian, long-term investment philosophy. If you think like a business owner (which we do), it is not one year’s worth of earnings that matters. Instead it is the prospective earnings stream over many years that matters, as this determines the value of the assets generating that earnings stream.
Staying ahead of the competition
Our approach relies heavily on independence and individual analyst accountability when assessing valuation. It also avoids relying on simplistic point-in-time metrics to screen and rank stocks. Aside from the possibility of the metrics (e.g. the point-in-time E in the P/E ratio) not being representative of the future, another issue with relying on screens of headline metrics is that most investors today have access to a screening tool, making them easy to replicate (hence the cheap pricing of ‘style’ index ETFs and ‘smart beta’ factor approaches). Something that looked good in back testing has experienced rapid growth in the number of people doing the same thing and increased competition leads to poor returns.
We suggest that while both value and growth stocks in general may go through periods of out- or underperformance, over time it is individual stock picking, via disciplined valuation, which really adds up. This is where Allan Gray and Orbis focus their efforts and over the long term this has translated into strong returns for our clients.
Past performance is not a reliable indicator of future results. Please consider the relevant Fund’s product disclosure statement before making an investment. These can be obtained from www.allangray.com.au (Allan Gray Australia Equity Fund) and www.orbis.com.au (Orbis Global Equity Fund).
Julian Morrison holds a Bachelor of Arts (Honours – University of Sheffield) and the Chartered Financial Analyst designation.