Most bond markets now offer negative real yields, even as the interest rate cycle starts to turn upward. Many stock markets are flirting with all-time highs. What should rational investors do?
Research Affiliates (How not to get fired with smart beta investing) earlier this year pointed to two credible responses. They highlighted that whereas “growth” and “quality” investing in the stock markets tend to underperform the broader market, “value” and “momentum” tend to beat the market over the longer term.
This conclusion reinforces the argument made by James O’Shaughnessy in his book What works on Wall Street, that “value” investing – buying the shares of decent businesses that are available at a temporary discount to their intrinsic worth – has the greatest potential of any style of equity investing to generate superior returns over the long run.
O’Shaughnessy ranked the US market by a variety of metrics – price/sales, price/earnings, price/book and price/cashflow – and then tracked a portfolio of the 50 most expensive - and 50 cheapest - stocks by each metric, over a period of 52 years. He then rebalanced those portfolios annually, so that they were consistently the most extreme "growth" and "value" portfolios over time.
$10,000 invested in the “growth” portfolio, for example, as assessed by the 50 stocks with the highest price/book ratio, ended up being worth $267,147 after that 52 years had elapsed. Which sounds impressive, until you see what the "value" portfolio of lowest price/book stocks returned. $10,000 in the "value" portfolio ended up being worth over $22 million. Value works.
The problem today is that there is so little obvious value available, at least in the Anglo-Saxon markets, but also in a number of emerging markets like China. Happily, there are exceptions. Over a third of Japan’s Topix index, for example, trades below book value. No other developed market offers a valuation discount close to Japan’s.
Japan’s prime minister Abe’s corporate reforms are real. Japanese companies are slowly but surely improving their commitment to shareholder returns. Stock buyback programmes are being initiated across the board; dividends are being relentlessly raised. And for the first time in years, there is now a strong bid for Japan’s stock market – from domestic investors, including the Bank of Japan, Japanese companies themselves, retail investors (in the form of NISA accounts, the equivalent of the UK’s ISA) and the Government Pension Investment Fund, the largest pension fund in the world.
Another Asian market worthy of consideration is Vietnam. The country has a population of 94 million, who are extremely well educated. Vietnam enjoys a literacy rate of 94.5% and regularly comes close to the top of the PISA international education rankings. Vietnam also offers some of the most competitive wage rates in the world – less than half those in China – which has made Vietnam the destination for foreign direct investment in south-east Asia.
And almost half the entire Vietnamese stock market sports an Enterprise Value to Cash Flow yield of over 15%. No other stock market comes close. Better still, most institutional managers are unable to access Vietnam - being deemed a “frontier” market – but Vietnam is likely to be upgraded from “frontier” to “emerging” market status in the next 2-3 years, which will likely trigger dramatic inflows into a market that has already lifted foreign ownership limits.
So while most markets, whether for equities or bonds, look overpriced and vulnerable, Japan and Vietnam look like a paradise for unconstrained value investors.
Tim Price is Director at Price Value Partners and manager of the VT Price Value Portfolio. He is also the author of Investing through the Looking Glass: a rational guide to irrational financial markets