The wrong kind of value rally

Welcome back. Tuesday flipped Monday on its head, mostly, taking back almost all the previous day’s losses. I wouldn’t have expected that on a day when the 10-year Treasury rose to breech 1.5 per cent for the second time in a week. Good thing I’m not in charge of analysing one-day market action. See below for some nerdy thoughts on somewhat longer-standing trends. Email me: robert.armstrong@ft.com

Value’s outperformance ain’t what it was

One theme that runs through much of the market action this year is the tug of war between value and growth — or, if you prefer, cyclicals and tech, or small cap and large cap. It is a contest between the pre-Covid regime, where economic growth and interest rates were low and technology ruled the markets, and the regime of higher growth and rates struggling to be born in the wake of the pandemic. Here’s a chart of the pattern (data from Bloomberg), showing the relative outperformance of value and small-caps:

Looking at value’s victories in the battles of the past few weeks, one might ask if we are going to have a sustained upswing in value and small-caps, as we did in the spring?

But the crucial point to bear in mind is that small-caps and value stocks led the market in the spring because they are growth sensitive. Now they are leading because they are rate sensitive. You can see the difference by looking at the relative performance of industrial stocks, which are value but all about growth, and banks stocks, which are value but are all about rates (Bloomberg again):

One way to frame the key issue for the coming months in markets is to ask whether those two lines can come together again, and exactly what might drive them to do so. I made this same point, in a more convoluted way, just the other day. But I thought it worth stating again, this time more clearly.

Value vs quality

I got my training in the market in a value investment fund, a fact reflected in this column’s mild-to-severe obsession with valuation. Value people think you win or lose the investing game on the first move: the price you pay for an asset is the most important determinant of the returns it will ultimately deliver.

It is standard to contrast the value approach with the growth mindset, which holds that if the asset grows fast enough, the price you paid rapidly becomes irrelevant.

But there is a third approach, one which might be particularly relevant at this moment: quality. On the quality view, what matters is not price or growth but profitability, specifically return on assets or equity. Quality investing is related to value investing, with a crucial difference. The value investor looks for high profit-earning power relative to market value; the quality investor looks for high profit-earning power relative to balance sheet value.

I’ve been thinking about quality investing because of an excellent short paper on the topic by Greg Obenshain of Verdad Capital. He asks why and when quality investing works, and answers the question by contrasting quality with value. His core point is that these two strategies work at different points in the economic cycle. Value works coming out of a recession and during the ensuing expansion; quality works during the fevered end of the cycle and the ensuing recession.

Here are the annual returns of the top quintile of quality stocks minus the returns on the top quintile of value stocks in different phases of the cycle (Obenshain measures quality by the gross profit/assets ratio and value as gross profit/enterprise value):

Why does it work like this? Value stocks are by definition cheap. They have been disregarded by the market because of suspect fundamentals. But in good times, the fundamentals recover, and the market takes another look. Obenshain decomposes the annual returns from the top decile of value stocks since 1996 and finds this (the typo in this chart is, for once, not mine):

Value stocks go up because their valuation multiples expand. The market recognises they are too cheap, and bids them up. Contrast quality stocks:

Quality stocks rise in value because their assets increase. They chug along creating profit, and one way or another, that profit tends to land on the balance sheet. This is why gross profit, rather than (for example) net profit, is a good numerator for quality ratios. Gross profit is the raw material out of which either distributable net profit or higher reinvestment is made. A company such as Amazon often doesn’t make very high net profit relative to its assets or its market price, but that’s because it reinvests aggressively, and that creates value. Amazon (which scores high on quality and terribly on value) has more than doubled its assets since the beginning of 2019.

Now this is particularly relevant just now because, at least judging by stock market valuations, we may be getting late in the cycle (though Covid has made the issue hard to judge). And late cycle is where quality stocks start to thrive. In conversation, Obenshain explained to me his thinking:

“When valuations are very high, all of a sudden dividends and return of capital mean less because they are a smaller number, relative to what you are paying. So growing the thing upon which you are valued — sales, profits, assets — is much more important.” 

I ran a quick quality screen of the S&P 500 after reading the piece, and this is the top of the list on gross profits/assets (data from CapitalIQ):

A lot of great companies there, but two are especially interesting. Domino’s is a sort of perfect quality story. As a franchiser, it is asset-light, but its profits grow with the franchisees, and those profits can be converted into more highly profit-generative assets. Ten years ago Domino’s was a $33 stock. Now it’s at $475. Whatever you think of the pizza, the business is a profit compounding machine.

Kroger’s shows you that screening for quality is not enough. Its assets generate a huge amount of gross profit, but the profit gets consumed lower down on the income statement. In the past 12 months it has $31bn of gross profits, but had $25bn in overhead expenses. The stock has been good but not spectacular over time. As Obenshain points out, you have to look at quality in an industry context.

A final, rather uncertain thought. People like to look at the valuation of the market. We are constantly reminded that the S&P 500 has rarely been more expensive. But what about the quality of the market? Here is gross profit/assets for the S&P over the last 20 years (CapitalIQ data):

What does this tell us? I confess to being unsure. Perhaps not much. One interesting thing is that there does seem to be a step-function increase in the aggregate profitability of the index constituents after the great financial crisis. Looking at the underlying data, it looks like unproductive assets may have been pushed off balance sheets, but it is hard to say. The second point is that right now S&P companies are just about as profitable as they have been in the past two decades; maybe that should make us more comfortable with valuations.

One good read

Some very important thoughts on sneakers.