The pain being felt by value investors may only intensify if global growth “turns Japanese” according to Hyperion Asset Management.
If you needed yet another sign of how tough the environment is for value investors, you only had to look at Saturday’s edition of AFR Weekend.
There on page five was a prominent advertisement from Platinum Asset Management, the globally focused contrarian investor founded by billionaire Kerr Neilson, with a simple message that appeared to be aimed at existing investors.
“Now it’s time to hold the line,” the advertisement said, explaining that “when the storm clouds of uncertainty start to gather … sentiment tends to nervousness and fear, and prices can respond negatively.”
Like many value investors, Platinum is coming off a tough year. Seven of its eight most prominent funds underperformed their benchmarks, funds under management slipped 4.1 per cent to $25.3 billion and Neilson and chief executive Andrew Clifford refused their bonus payments.
Clifford has been realistic in saying Platinum’s numbers are unlikely to turn quickly, but as the ad says, the firm is equally confident that the worm will turn.
But there’s one problem. In a lower-for-awfully-longer world, it’s very hard to see what triggers the resurrection of value investing, and, conversely, the end of the stellar recent run of growth investing.
Growth investor Mark Arnold, who is the chief investment officer at Hyperion Asset Management, is blunt when he says value investing is dead.
Arnold argues the strategy that sits at the heart of value investing – finding undervalued companies that will eventually be re-rated by the market, which he describes as buying “average companies at below average prices” – will no longer work when the tailwind provided by strong GDP growth disappears.
“Your average business is heavily reliant on the economic pie growing,” he says. “And most businesses are pretty average.”
Arnold, whose global fund produced a return of 17.5 per cent in 2018-19, is cleverly making two points here.
Firstly, he paints an ugly picture of a global economy set to enter a long period of stagnation, where the days of high nominal GDP growth are replaced with the sort of no-growth environment that has haunted Japan for decades.
Partly this economic environment is the product of 50 years of ever-growing debt levels, which has made governments, businesses and households fragile. It’s also partly about the ageing population, which will provide an unavoidable weight on GDP growth. And it’s also related to what Hyperion deputy chief investment officer Jason Orthman describes as the complete unwillingness of central banks to expose markets and communities to any sort of short-term pain.
“We think the world is gradually turning Japanese,” Arnold says.
His second point is that this environment creates enormous pressure on company revenues and margins – pressure that is only being intensified by technological disruption. Arnold and Orthman say it’s already weighing on returns, and claim 90 per cent of listed companies have seen returns on equity decline since the 1990s.
“People haven’t really noticed that the intrinsic value of 90 per cent of listed businesses is in decline,” Orthman says.
The Hyperion view is that focusing on the top 10 per cent of companies based on return on equity – and then an even more narrow focus on the really exceptional firms in this narrow universe – is what will work.
It is a classic growth investor’s view of the world. But Arnold insists it’s a strategy built for a long period of stagnant economic growth, when firms with strong market positions, pricing power and the potential to tap big addressable markets can thrive despite economic conditions.
Hyperion’s global growth fund is stacked with plenty of classic growth names. Alphabet (parent company to Google), Facebook, Amazon, PayPal and Mastercard are its five biggest holdings.
Arnold shrugs off concerns these are crowded and expensive trades, arguing that Hyperion considers their value over a long time horizon; its average hold period is 10 years.
But it will constantly “top and tail” its portfolio where a specific stock moves away from what Hyperion sees as its intrinsic value. Bad news that weighs on the stock might see them do some buying, and they will take profit when a share price overheats. Arnold says 50 per cent of the alpha Hyperion generates comes from this tactic.
The firm’s funds contain 15 to 20 stocks, with one or two stocks added and removed each year.
Hyperion’s locally focused funds, the Australian Growth Companies fund and the Small Growth Companies fund, haven’t done as well as the global strategy, returning 5.9 per cent and 9.3 per cent respectively during 2018-19.
Arnold says it can be harder to find the sort of growth companies Hyperion likes in the smaller universe of Australia.
“We like modern businesses that invest in R&D and these businesses are hard to find in Australia,” he says. “Everyone is focused on maximising short-term profits.”
REA Group has been a standout in both funds. Hyperion bought in at 86¢ and it is now trading at a touch over $100.
Orthman nominates Xero as one of the firm’s top picks in the software-as-a-service space, and Nanosonics as a company to watch in another favourite sector, healthcare. He argues both companies have big growth opportunities ahead of them over the next decade.
Orthman also has an interesting way for investors to think about company management in the last two weeks of reporting season: Missionaries versus mercenaries. The former – those leaders who live and breathe the business, and have plenty of skin in the game – are what Hyperion like.
Of course, it’s not a foolproof strategy. Domino’s Pizza and Corporate Travel Management were two of the big detractors from the returns of the Australian funds in 2018-19. The market wasn’t rapturous about their profit numbers last week, either.
Nor surprisingly, Arnold is not undeterred.
“Founder-led businesses like Seek, Domino’s Technology One and WiseTech have all been strong performers since listing. In founder-led businesses, management teams have the advantage that they are normally in a position to take a long-term, strategic-based decision, even if that means reporting lower profits over the short term. “
Written by James Thomson
This article was originally published on Australian Financial Review.