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Risk of missing out on “Value”

Recent underperformance of “Value” has been misunderstood

Investors who have witnessed a decade of value style underperformance may understandably harbour indifference and caution towards this investment approach. The significant extent of underperformance has fostered a perception that “value investing” inherently carries a higher degree of risk relative to other styles. Traditionally, this perceived risk often led to robust outperformance, interspersed with brief periods of underperformance. Yet, in the decade following the 2008 global financial crisis (GFC), the value investment style suffered its most severe and prolonged period of relative underperformance. This was true both in South Africa and global markets [Figure 1].


While various explanations exist for this underperformance, AQR Capital Management published an article in May 2020 titled ‘(Is Systematic) Value Investing Dead?’. In it, they argued that none of the typically cited “structural reasons” for such underperformance were applicable in this case. Specifically, they found that the following factors did not contribute in a statistically significant manner to the style’s underperformance:


  • The rise of monopolies which command higher valuations
  • Benchmark changes in sectoral exposure
  • Technology over-valuation
  • Mega-caps over-valuation
  • Cheap for a reason (low profitability, high leverage)
  • Low interest rates

If not these more common place reasons, then what exactly has been the reason for Value investing’s decade-long underperformance?  We identify two important contributors.

1. The positive market sentiment has been (over) accentuated.


A good starting point might be to explore why value investing has been successful in the past. The value premium emerges because the market often overvalues companies (as indicated by share prices and price-to-earnings ratios) that are in favorable positions and, conversely, undervalues those in less favorable positions. The market then tends to project these current conditions indefinitely into the future. This leads to overvaluation in segments that are viewed positively, and the opposite in negatively viewed segments. Although this tendency has always existed, in recent times the market has significantly overemphasized the positive and underemphasized the negative more than usual. This shift has prompted some analysts to suggest that the relative opportunity for value investing is now greater than ever before. The disparity between value portfolios and the market is nearly 3 standard deviations wider than the historical average, exceeding the levels observed prior to the Tech Bubble and before the global financial crisis (GFC), in both developed and emerging markets [Figure 2]. As illustrated by the graph, following these periods of extreme divergence, the market underwent a correction as prices and valuations adjusted, leading to a period of outperformance for value investing. This indicates that industry-neutral growth indices are at record highs relative to value.

2. South African market returns also came from multiple expansion.


Equity returns comprise 3 elements: Dividend + Earnings growth + Change in P/E multiples.


Figure 3, particularly between 2014 and 2018, clearly demonstrates that the recent period of underperformance in value investing coincided with equity returns being propelled by expanding valuation multiples, where price increases outpaced earnings growth. This marks a departure from the historical norm, where earnings growth and dividends primarily fueled returns. In an environment where returns are influenced by less predictable factors, such as price-to-earnings (PE) multiples, investors who rely on fundamental valuation tend to underperform relative to the market. This dynamic was further intensified by low earnings growth, which limited opportunities for investors to find compensatory earnings returns.

Value is a useful source of uncorrelated alpha

Although the value investing style is often linked with higher relative risk, it provides several key advantages that are beneficial for constructing investment portfolios. Most importantly, it introduces an element of negative correlation to portfolios. Historically, with its emphasis on book value, value investing has tended to outperform other investment styles during economic downturns and market drawdowns. The negative alpha in value investing’s performance usually manifested during periods of strong overall market returns, followed by significant outperformance during market downturns. It is plausible to argue that the prolonged up-cycle following the global financial crisis (GFC) may have played a role in value’s underperformance. However, in the years 2021 through 2022, as markets began to show signs of a typical weakening cycle, the value style once again exhibited its defensive characteristics. 


This feature has often occurred throughout history [Figure 4 and Figure 5].

Generating alpha from value investing and enhanced portfolio quality

Considering the value style’s underperformance over the past decade, it is reasonable for investors seeking exposure to the Value factor to inquire about the measures a manager is implementing to outperform the style. Below are the steps we have undertaken, which we believe will contribute to outperforming the style itself:


1. Stock-selection


Due to the attractiveness of the universe, the Perpetua team has become more selective in our stock picking. We are buying businesses that have:

  • Strong balance sheets
  • High and growing dividend yields
  • Value unlock catalysts such as asset sales and share buybacks
  • Higher quality and strong competitive positions
  • Good management teams
  • Lower ESG risk factors

Because of these stricter stock selection criteria, we believe that drawdowns from our active positions will be minimized. Outside of Naspers (which contributed most notably to our relative underperformance until 2020), the counters that previously detracted were companies with weak balance sheets (e.g. Brait). Currently, the balance sheet position of the portfolio is much improved as many companies have de-geared over the last few years and are more focused on strict capital allocation.  


2. Value has become more broad-based


During the period 2012-2015, there was a wide dispersion of valuations amongst the listed counters on the JSE [Figure 6].

The chart above visually represents our findings at the time, which were supported by our bottom-up research. During the 2012-2015 period, we were finding significantly more value in the resources sector, leading us to allocation a high active weight to this sector (+ 16%). This allocation was funded primarily from the General Industrials sector (-13%) and more specifically Naspers, resulting in concentration risk in the fund’s performance profile.


Currently we observe that:

  1. The overall market is cheaper than the previously mentioned 2012-2015 period.
  2. The attractiveness is more broad-based across the market and the disparity in valuations has narrowed.

As a result, our portfolios are less concentrated in a single sector [Figure 7]. The most significant absolute active position is an overweight position in Healthcare (4.6%).

The broader diversification of our portfolio means we are less vulnerable to the fluctuations of any single sector. While we acknowledge that our approach may evolve in response to market dynamics, a significant shift would require one of two scenarios:


  1. Our positions perform well, generating alpha for our clients as we adjust our holdings.
  2. Our positions underperform compared to the market, and a more compelling, higher-quality sector becomes apparent.

Should the latter scenario occur, we anticipate that the cautious sizing of our active positions will mitigate the risk of substantial underperformance. Some might interpret this diversification as indicating a lack of conviction in our portfolio choices. However, we view it differently; by spreading our investments across various sectors, we believe the portfolio is better positioned to achieve its return objectives with reduced exposure to any single risk, aside from the overarching market risk.

3. Improved risk management practices and processes


In light of the market conditions mentioned above, Perpetua has leveraged the lessons and feedback from the past decade to enhance our risk management processes and practices. We engage in discussions on portfolio risk through two primary forums: a monthly Investment Risk Committee meeting and a fortnightly Portfolio Managers’ meeting.

The Investment Risk Committee meeting focuses on reporting the current fund position, risk exposures, and attributes. It also identifies, quantifies, and addresses any significant investment and operational risks. Meanwhile, the Portfolio Managers’ meeting is dedicated to identifying market opportunities and risks associated with our current positioning. The discussions in that meeting focus on the following risk factors:

Market opportunity and process refinements benefit Perpetua client portfolios

In conclusion, the past decade has marked the most severe and prolonged downturn in the history of value investing. However, more recently, there have been indications of a recovery. We believe that specific factors, such as the market’s narrow return profile, have intensified the underperformance experienced. We have identified opportunities across various sectors, significantly reducing our risk of sector concentration. This approach will help shield against the effects of a narrow market, should it occur again. Moreover, Perpetua has refined its processes in stock selection, risk management, and portfolio construction, positioning our client portfolios for improved outcomes. These enhancements will counteract the adverse effects associated with the value style, while maintaining our core identity as valuation-based investors.