10 10/18 10/10/2018

Revenge of the Value Nerds

10-10-2018 12:45,
Léon Kirch

Léon Kirch, Partner and CIO of European Capital Partners, writes a weekly market commentary. We're glad to share his insights, leading up to the International Value Investing Conference on October 23 and 24.

Revenge of the Value Nerds

Let’s take a step back for a moment from the current market turbulences around Brexit and Italy and imagine that we had thrown in the towel on fundamental value investing in September 2008 at the Lehman crisis.

During the following 10 years, we assume we decided to retire to the cozy beaches of Italy as we had reached the conclusion that fundamental analysis and valuation would not matter at all in an environment driven by the quantitative easing measures applied by the central banks.

Our investment strategy would be simple and low on maintenance: we invest in the 10% of European companies that had shown the best stock market performance over the previous 100 days. We rebalance the portfolio quarterly to be sure to own the portfolio of the most glamorous stock market winners. We call the strategy ‘lazy momentum’ as it does not require lots of maintenance and skill.

Fast forward 10 years, here are the results compared to the market overall according to a Bloomberg back-testing:

 Source: Bloomberg, gross performance without transaction costs.

We are not surprised that the results of this strategy are outstanding as equity markets have been driven by momentum and valuations were ignored. However, we are convinced that, over the long-term, in a normalized interest rates environment, these momentum driven strategies are unsustainable.

As Warren Buffett is famously quoted: "Only when the tide goes out do you discover who's been swimming naked".

As interest rates start to increase and central banks are winding down slowly on their asset purchase programs, we believe the tide is about to turn and find it dangerous to ignore fundamentals and valuations.

For us, value investors, such a "lazy momentum" portfolio proves to be quite risky: with a ROE of 6.4%, the profitability of the average company in the current momentum portfolio is low while its valuation is high ( 43.4 times trailing PER). In comparison, the average company in our current European company at ECP has a return on equity of 17,6% and trades on less than half the valuation of the momentum stock in terms of PER.

So value investors are sleeping better at the end of the market cycle than their momentum counterparts: going forward, beware the revenge of the value nerds who have not been sunbathing on the Italian beaches.



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