What to do with an effective long-term investment strategy, in a market with attention-deficit syndrome?
Why do we care about value? Part of it is obvious: Buying assets for less than they’re worth makes intuitive sense—and certainly seems wiser than doing the opposite.
Perhaps value investing also denotes a level of courage and seriousness that other factors lack. An investor who proclaims “carry” to be the secret sauce may sound naïve. An investor who proudly embraces “momentum” has to explain what’s so special about “buying what’s going up.”
Buying what seems cheap, in contrast, often requires going against the grain—almost by definition, seeing value where the rest of the world doesn’t. Count me in.
Value does come with a drawback: It needs time to work. Indeed, value has the impressive property of being extremely effective over long horizons, and extremely ineffective over short ones. For example, the price-to-book value of the S&P 500, the broad benchmark of the U.S. market, has historically explained around 70% of returns over the next 10 years. But it has explained less than 10% of returns over the next 12 months.
Patient value and flighty momentum are a bit of an odd couple.
This makes sense. Value relies on the idea that certain assets have deviated materially from their true worth. Why should that kind of imbalance correct quickly? But, in a world obsessed with quarterly, monthly or even weekly performance, this can be a problem. Value requires patience, in a market that often lacks it.
This message holds for other assets too. Common measures of valuation, such as real yields, loss-adjusted credit spreads, or real effective exchange rates, pretty effectively explain long-term returns for their asset classes—bonds, options, and currencies, respectively. But none has been terribly effective predictors of the next 12 months.
This challenge is apparent when trying to apply value in a systematic way. In recent work from my colleague, Senior Cross-Asset Strategist Phanikiran Naraparaju, we simulated strategies of regularly “buying cheap” and “selling rich” across equities, credit, rates, currencies and commodities. We looked at this on both a “time series” (valuation vs. history) and “cross sectional” (valuation vs. peers) basis. Neither was particularly effective. To my (mild) annoyance, those less intellectually appealing strategies, momentum and carry, performed much better under similar systematic rules.
Is value hopeless? Hardly. Firstly, analysis from Wanting Low, my fellow Cross-Asset Strategist, shows that valuation remains a powerful—indeed the most powerful—predictor of returns on a five-year basis, across a variety of markets. Second, systematic value strategies can be more effective when combined with momentum.
True, patient value and flighty momentum are a bit of an odd couple. But they do work well together. After all, the problem with rules-based value investing is its tendency to sell too early in bull markets, and buy too early in bear markets. An additional test for momentum helps to address this.
Why does this matter today? A number of value assets now also show momentum: China and Korea equities, the Brazilian real and South African rand, as well as oil, all have reasonable valuations on their five-year range, and positive one-year price momentum. European value, a growth underperformer for the better part of a decade, is starting to claw back returns. Our European Equity Strategist, Graham Secker, notes that it would be highly unlikely for such a reversal to stop here—one reason he’s overweight value.
This story isn’t just top-down. Banks need to participate for value to work in Europe, and our equity analysts are constructive, citing improving revisions, low valuations and feedback from the recent Morgan Stanley Financials Conference in London. While value requires patience, we are hopeful that, at the moment, less waiting is required.
Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (Apr 2, 2017) series. Ask your Morgan Stanley representative or Financial Advisor for the latest macro and strategy coverage and reports. Plus, more Ideas.