This white paper is based on a lecture given to the Portfolio Construction Forum in Sydney on the 22nd of August 2019 by Mark Arnold.
Figure 1: Value underperforms in periods of low nominal GDP growth
Although value investing has, on average, resulted in strong performance since the Second World War due to extremely high levels of economic growth, our premise is, that in times of low growth and low inflation value investing underperforms. Figure 1 illustrates this point by plotting the performance of the Fama French HML Index since 1926. It shows that in low nominal GDP growth environments, value investing underperforms (the red dots in Figure 1). Without a doubt we are entering a low growth world, in this world we purport that the value anomaly is dead.
The following paper covers six key points that underscore our thesis: in a low growth, low inflation, low interest rate world the value anomaly is dead.
- We review the evidence that the extraordinary “economic growth bubble” that occurred primarily during the period 1950 to 2007 and gave rise to the value anomaly was the result of tailwinds that have weakened or expired.
- We explain that the nature of value investing relies on the performance of average quality businesses whose economic success is highly reliant on broader economic growth and confidence.
- We review economic growth over a longer time horizon to show that more recent levels of economic growth have been abnormal in the context of a wider history and consider what this implies for future economic growth rates.
- We observe that global economic growth has slowed since the GFC as a result of reducing tailwinds and increasing headwinds. The world is in the process of turning “Japanese” in terms of growing acceptance of ultra-loose monetary and fiscal policy settings.
- We forecast that low growth will persist as a result of increasing global economic headwinds.
- Finally, we analyse the implications of a low growth, more competitive world for average quality businesses and portfolio construction over the next decade. We focus on the importance of being style awareand investing selectively in quality winners, not value.
(i) 1950s to 2007: Substantial tailwinds support the value anomaly
The period from the 1950s to 2007 was one of extremely strong economic growth that was unprecedented in history. There weresubstantial tailwinds that contributed to this strong six-decade period of economic growth. In this “economic growth bubble”, average quality businesses performed well because extremely high economic growth rates resulted in the benefits being shared amongst many. During this period, competition levels were generally benign which also benefited average businesses more than higher quality businesses. Low levels of competition were at least partly a function of the strong economic growth rates experienced during this period. There is a general inverse relationship between economic growth rates and levels of competition. In addition, disruption levels were low during this six-decade period. Value investing was the dominant investing style during this period.
Although this period is still familiar to most of us and we would like to return to this period of strong economic growth, there are real fundamental reasons to think that this high growth period permanently ended over a decade ago. Further, from a long-term macroeconomic perspective, this six-decade period was an extremely abnormal and unusual period in history. It was a period that is unlikely to be repeated over the next decade.
Figure 2: Global GDP growth during the “economic growth bubble” period
Figure 2 shows Global GDP in the “economic growth bubble” period leading up to the GFC. This was a period in history of extraordinarily strong economic growth. Global GDP growth averaged 4% in real terms and over 8% in nominal terms and the size of the global economy increased by 8.5 times over this time. Strong nominal growth is particularly important for the value anomaly because average quality businesses are highly reliant on rapid nominal GDP growth for their sales growth.
Substantial tailwinds during this period, supported both strong growth in nominal GDP and the value anomaly.
These economic tailwinds included the following.
- A massive increase in economic growth as a result of strong population growth. Productivity growth was boosted by young populations, lower levels of disease and sickness, longer life expectancies and women entering the workforce.
- The financialisation of society, which allowed people to spend more than they earned and brought forward economic growth.
- An expansion of a robust middle-class, at least up until the 1970s, which boosted levels of economic growth. Alarge andgrowing middle class is key to high levels of economic growth, given that consumer expenditure represents the largest component of most major developed economies.
- On-going confidence in the economic outlook partly because of recency bias, momentum-based feedback loops, and a general belief that central banks and governments had the power to ensure that future economic growth rates would be strong. Even during periods of low growth or recession there was a general confidence that governments and central banks would be able to restore high rates of economic growth in the future. People born into the high growth world accept this as normal and permanent.
- The development of powerful machines driven by cheap fossil fuel-based energy. Moving from an economy with no powerful machines to an economy with an abundance of powerful machines dramatically boosted productivity growth during this period.
- A general belief that there were abundant natural resources that would always be available to fuel strong economic growth. The natural world was considered large compared with the global economy and climate change was not considered a threat to growth.
- Lower levels of competition and more limited levels of globalised competition.
These tailwinds were considered normal and permanent at the time. However, these tailwinds were unique to this phase of economic development and when viewed in the context of the history of civilisation were temporary and one-off in nature. Even though the high rates of economic growth were considered normal and sustainable, from a long-term historical perspective, they were very abnormal, unusual and unsustainable.
Population growth was a key tailwind that peaked in the 1960s when it averaged in excess of 2% per annum. However, since the 1960s global population growth has been in steady decline, as shown in Figure 3.
Figure 3: Global population growth rates peaked in the 1960s
Traditional value investors tend to focus on investing in average businesses that are heavily reliant on the overall economy. If the economy grows strongly, then the average business tends to grow strongly. However, if the economy experiences low or negative growth, these businesses tend to suffer badly. The profits of these average businesses are highly leveraged into economic growth because they normally have significant operating and financial leverage. An average business can usually grow its sales organically in line with nominal GDP. With the help of operating and financial leverage, it can then grow its profits above the rate of sales growth. However, in a lower growth economy, the average business suffers because it has not spent heavily on improving and innovating its product set through R&D and thus finds it difficult to grow its sales above the rate of overall industry growth. In addition, in a low growth economic environment the competitive intensity of most industries tends to increase placing even more pressure on the profitability of average and below average businesses.
The financialisation or gearing up of society was a unique occurrence. Moving from low levels of debt to high levels of debt brought forward consumption and investment. However, this increased level of gearing only provided a one-off boost to economic growth. High debt levels impede future levels of economic growth because it makes households and businesses more fragile and risk adverse.
The creation of a strongly growing middle class was also a one-off driver of strong economic growth. In developed market economies, consumer expenditure growth is a key determinant of economic growth. Prior to the second industrial revolution the middle class was weak, the standard of living for most of the population was low and inequality levels were high. The unique combination of the creation and growth of a large middle class and the simultaneous achievement of massive increases in productivity formed a virtuous loop driving extraordinarily high levels of economic growth in the period from 1950 to 2007.
The development and commercialisation of powerful machines, driven by cheap oil and coal, had a massive positive impact on productivity. This resultant lift in productivity is unlikely to be replicated over the next decade.
The benign levels of competition were also a temporary occurrence that was largely a function of the extraordinarily strong levels of economic growth, reducing the natural level of competition in key industries. In addition, internet and smart phone enabled global competition emerged only in the last decade or so and until the emergence of those technologies disruption levels were generally low.
Economies, industries and businesses go through life cycles. The global economy experienced peak growth in the six decades leading up to the GFC. This was an “economic growth bubble” that was temporary and directly resulted in the creation of the value anomaly.
(ii) The value anomaly was born on these tailwinds.
In the “economic growth bubble” of 1950s to 2007, average quality companies grew revenues at high rates (in-line with nominal GDP) as they shared in the strong growth of the economy. The average nominal rate of global GDP growth during this extraordinary period was above 8% p.a. and approximately 7% p.a. for the US economy.
Corporate sector revenues tend to grow in line with nominal GDP over time. For businesses there are two potential sources of revenue growth: 1) sharing in the growth of the overall economy; and 2) taking market share. Average quality businesses have limited ability to organically increase market share, therefore, they are normally highly reliant on economic growth in order to be able to grow their sales. Thus, during the “economic growth bubble” period, average quality businesses could grow their revenues organically at attractive, high single digit rates merely because the overall economy grew at these high rates.
Examples of average quality businesses include the large banks, mature traditional retailers, building materials businesses, cyclical commodity businesses, capital intensive industrial businesses and traditional manufacturing. These types of businesses benefited more than high quality businesses because their organic revenue growth is normally solely reliant on growth in the size of the economic pie. In contrast, high quality businesses are less reliant on the growth of the overall economic pie because they can organically grow revenues by taking market share.
The fundamental performance of average quality businesses was further enhanced by the natural inverse relationship between the rate of economic growth and the level of competition. Average businesses benefited relatively more than high quality businesses because they are more sensitive to competition levels. High quality businesses can deal better with higher levels of competition because they have stronger value propositions and competitive advantages. Thus, high quality businesses benefited less in a relative sense during the high growth, less competitive decades leading up to the GFC as it was easier for all businesses to get a share of the growing economic pie.
Further, disruption levels were low during the “economic growth bubble” period, with most major established industries enjoying extended periods of competitive stability.
During this high growth economic environment, operational and financial leverage was employed by average quality companies to further boost EPS growth.
Confidence in the sustainability of economic growth was high because people were conditioned to believe that high levels of economic growth were normal and sustainable.
Value stocks (low P/E, low P/B) did well for two reasons during this period:
- EPS growth was strongly positive for average quality companies.
- Growth in P/E was supported by confidence in future growth.
Successfully investing in equities is primarily about achieving growth in real earnings over the holding period. Traditional value investing relies on both EPS growth and P/E expansion during the holding period. If the EPS growth is weak during the holding period, then the value investor is solely reliant for success on P/E expansion. The problem is that the terminal P/E is determined by the confidence that the future EPS will grow. This assessment is at least partly influenced by recent historical fundamental performance. Thus, the terminal P/E (the P/E when the investor sells) is heavily influenced by recent historical EPS growth. These two factors, historical EPS and terminal P/E, are positively associated with each other. During strong growth periods more average quality businesses do well in terms of EPS growth and this tends to support market P/Es for average quality businesses. During the six-decade “economic growth bubble” leading up to the GFC, average quality businesses reported strong EPS growth. This strong EPS growth enhanced terminal P/Es for average quality businesses and contributed to the strong performance of value style investing during this period. Even if a value investor failed to predict a recession, they could be confident that the government and central bank would ensure a recovery and return to strong growth in a relatively short period of time because the tailwinds were still strong.
Value investing does not work if the earnings of the businesses do not grow over the holding period. If earnings decline materially over the holding period, then value investing will not protect capital and will result in poor investment returns.
Ben Graham, Warren Buffett and key academics made value investing the dominant style at this time.
The value anomaly was born as a result of the factors we have discussed above.
(iii) Looking at growth over a longer historical window
If we look further back in time, we find that the high economic growth rates achieved in the second half of the 20th Century were abnormal. Prior to the 20th Century and the Second Industrial Revolution, there was very little economic growth for thousands of years. In a long-term sense, low economic growth is more accurately described as “normal” and the strong economic growth rates experienced in the second half of the 20th Century are better described as “extreme and unusual”. Moreover, the tailwinds that drove these periods of high growth rates were largely temporary in nature.
Prior to the second industrial revolution, the tailwinds that created the “economic growth bubble” did not exist.
- Life expectancy was short, disease was rife and as a result productivity was poor and did not improve materially over long periods of time.
- The banking system was not developed, and it was difficult and expensive to get credit.
- The middle class did not exist, inequality was high, and most people lived in poverty. Feudal type systems dominated economies for long periods of time.
- Confidence in future economic growth was low because the economy did not grow.
- There were no powerful machines and virtually no specialization of labour, so productivity was low and did not improve significantly over time.
- High levels of corruption hindered economic growth.
The following two charts, Figures 4 and 5, show in greater detail the long-term growth profile of the global economy.
Figure 4 shows that for thousands
of years, prior to the first industrial revolution, there was very little
economic growth and then there was explosive, exponential growth.
Figure 4: Explosive Growth in Global GDP Driven by Temporary Tailwinds
Figure 5 shows the rate of economic growth over different time periods. This chart shows the rate of economic growth started to accelerate rapidly in the late 19th Century and peaked in the six decades before the GFC, driven by temporary and unsustainable tailwinds. The average growth in real global GDP during the six-decades leading up to the GFC was approximately two times the average economic growth rate in the period from 1871 to 1950.
Figure 5: Real GDP growth peaked in the six-Decades leading up to the GFC
(iv) Having seen that in the long term, low growth is normal, we can also now look at the period since the GFC.
Since the GFC, economic growth rates have slowed significantly from the peak levels achieved in the decades prior to the GFC and tailwinds have been reducing and headwinds increasing. During the last decade the value anomaly has disappeared, and traditional value style investing has significantly underperformed. We analyse the consistent poor performance of the value style of investing in low growth and difficult economic circumstances and find that the evidence is clear; value does not protect you when you need it most, in times of economic and market stress.
The following chart, Figure 6, shows the strong rates of economic growth experienced by the US and the Global economy prior to the GFC and the substantial decline in the average rate of economic growth after the GFC.
Figure 6: Economic Growth Rates Have Slowed Post GFC
The chart in Figure 7 shows the significant declines in the average rate of nominal GDP growth in the post GFC period compared with the “economic growth bubble” period for both the US and global economies. Nominal GDP is particularly relevant to the success of value style investing because average quality businesses are highly reliant on nominal GDP growth.
Figure 7: US and Global Nominal GDP Growth Rates Have Declined Post GFC
At the same time as the move to lower growth, there has been a material increase in the level of competition.
Figure 8 shows stocks in the MSCI World Index by decile ranked by profitability from 1981. The top line shows the most profitable decile. Prior to the internet, the top decile’s relationship with the other deciles was relatively stable over time.
Higher economic growth and less global competition prior to the internet and the GFC helped average businesses maintain profitability and grow sales with the economic benefits more equally shared.
Since the internet became established the ROE of the most profitable companies (black line with yellow markers) has increased and average and below average businesses’ ROE has deteriorated, particularly since the GFC.
Figure 8: The Internet Enables Globalised Power Law Distributions of Value Creation
Over the past decade and a half, it has become an internet enabled; winner takes all market. However, even before the internet, returns for global equity markets had been dominated by a few highly successful businesses and lots of average quality businesses that produce long-term returns at or below returns of Government debt securities. The returns produced by US equities from 1926 to 2016 were derived from an extremely narrow group of stocks that generated abnormally large long-term returns. This has been replicated in numerous exchanges globally. Positive skews and compounding actually create excess mean returns from large values in the tail (the winners). Power law distributions rather than normal distributions drive long-term stock market returns. Unless an investor has the ability to successfully select structural growth companies, the winners, portfolio returns will be unsatisfactory. Alternatively, ‘investors’ can attempt to out-perform over short-term time periods, although successfully predicting the direction of short-term share price movements is very difficult. This is an extremely competitive space and share prices are typically random over short time periods. Short term speculation will become even more challenging as economic tailwinds and rising intrinsic values are replaced by economic headwinds and falling intrinsic values.
Historically your typical “average quality” equity has produced long-term returns either below or in line with treasury bills. The average US equity listing period from 1926 to 2016 was only 90 months despite largely being a golden period for economic growth and investment.
So even in the unsustainable “economic growth bubble” period, average quality businesses were unlikely to produce attractive long-term returns and thus short-term trading through P/E mean reversion and EPS recoveries was important. This short-term strategy becomes very difficult in a low growth, disrupted environment because average quality businesses are more likely to suffer future declines in economic fundamentals rather than recover through mean reversion. The implications for investing in average quality businesses in a low growth, internet enabled globalized and disrupted world are clearly negative for value investing as a style. It will progressively be harder to apply short-term mean reversion techniques (EPS growth and P/E arbitrage) in this more difficult economic environment. Stock selection and actively avoiding average and below average quality businesses will become even more important in a disruptive, competitive, low growth world. Most businesses will fail and die. We will return to this topic in more detail and with supplied references in future white papers.
Figure 9 shows stocks in the MSCI World Index by quintile, ranked by profitability, but only shows the middle 3 quintiles of average businesses. The red line represents the “core” average quality businesses and it shows a material decline in ROE over the past 2 decades.
Lower returns on capital combined with lower rates of sales growth means these average quality businesses have experienced deteriorating intrinsic values. This has made it a more difficult environment for value style investors, as the frequency of value traps has increased significantly.
Figure 9: The Intrinsic Value of Most Businesses is
Declining in a Low Growth World
Figure 10 shows the outperformance of the value style in the 3 decades prior to the GFC and the underperformance of the value style after the GFC.
The underperformance of the value style since the GFC has been caused by: 1) lower levels of economic growth; and 2) higher levels of competition.
Figure 10: Performance of Value vs Growth
But we should look back further in time to better understand value investing performance in different economic circumstances. The following chart, Figure 11, is based on the Fama French value versus growth portfolios since 1926. The chart shows that even though the value style outperformed significantly over the period from 1926 to today, almost all the outperformance was clustered in periods of strong nominal economic growth. Value outperformed because the periods of difficult economic conditions were relatively short and shallow, and the periods of strong growth were much longer.
Figure 11: Value underperforms in periods of low nominal GDP growth
Value has consistently underperformed in difficult economic circumstances where nominal GDP growth is lower and the outlook for average quality businesses is poor. Value has generally not protected capital when you need it most, when economic growth is low.
The red dots in Figure 9 show the periods associated with weak nominal GDP growth. In the vast majority of low nominal GDP growth periods, value has underperformed. Starting with the great depression in the late 1929s and early 1930s, value underperformed, in the recession in 1938, value underperformed – recession in 1947, 1953, 1958, 1960, right through to the GFC. Nominal GDP growth was strong during the recession in 1974 because inflation was at double digit levels and thus average quality businesses performed relatively well during this period because their sales growth (in nominal terms) was still strong. In addition, value stocks were less impacted by the material increase in bond yields that occurred during 1974 compared with growth stocks. Value tends to perform poorly in recessionary conditions unless these conditions are associated with high levels of inflation and higher interest rates. Nominal GDP growth, levels of competition, severity of disruption and confidence in future nominal GDP growth rates are the key factors in determining value style performance.
Value style investing is a fair-weather investment
style. It is not a defensive investment style that protects capital in
difficult economic circumstances. It is an investment style that does very well
in accelerating and high growth economic environments, when confidence levels
are high and competition levels are low and declining. Conversely value style
investing performs very poorly in decelerating and low growth economic
environments when competition levels are high and increasing.
The world is turning “Japanese”
We can see similarities between the policy setting of most major economies around the world since the GFC and the policy setting of Japan over the past three-decades. Japan has experienced low levels of economic growth for three decades. Aggressive fiscal and monetary policies have been ineffective in terms of returning the economy to high levels of sustained growth.
The rest of the world is copying the Japanese policy blueprint of low interest rates, quantitative easing and fiscal stimulus.
Our interest in Japan is around its policy settings not its investment framework. It should be noted that Japan has a very unusual operating environment driven by unique policies around immigration, management, competition and employment. Although many countries will most likely follow Japan’s policy settings in a low growth world, the factors that drive investment related style performance will vary significantly.
(v) Economic headwinds will ensure lower growth in the 2020s and beyond
In the next decade, we are likely to experience further declines in economic growth rates as tailwinds continue to fade and headwinds continue to build. There are numerous headwinds building and we have selected four key headwinds to discuss in more detail.
The key headwinds to consider are:
- ageing populations and declining population growth rates;
- high debt levels;
- hollowing out of the middle class and rising wealth inequality; and
- climate change.
Ageing populations and declining population growth rates
The first major headwind is an ageing population. Most major economies have ageing populations and low levels of population growth (refer Figure 12). Japan is the leader with over a quarter of its entire population 65 years or older (red line). Older people work fewer hours, earn less income and contribute less to GDP. This headwind will be a drag on future rates of economic growth.
Figure 12: Declining Population Growth Rates Are Driving Ageing Populations
High debt levels
The second major headwind is high
debt levels. The world has geared up since WW2. Figures 13 and 14 show the debt
to GDP of the two largest economies in the world (US and China). China’s debt
to GDP as shown in Figure 13 has increased significantly since the GFC.
Figure 13: China Debt to GDP Has Increased Significantly since the GFC
Figure 14: US Debt to GDP Has Increased Significantly since the GFC
Both the US and China have geared up, households have geared up, businesses have geared up and governments have geared up. High debt makes households, businesses and governments more fragile and results in lower levels of future economic growth.
Hollowing out of the middle class and rising wealth inequality
The hollowing out of the middle class and the disruption of human capital markets by AI and robotics both represent major headwinds to economic growth over the next decade.
A robust middle class is essential for sustaining high levels of economic growth. There has been a hollowing out of the middle class since the 1970s,which originally started as a result of outsourcing jobs to third world countries, particularly China. This was a wage arbitrage strategy by large corporations. It led to significant middle-income job losses. At the same time there was strong growth in lower income “gig” economy and service jobs.
The hollowing out of the middle class is likely to continue as a result of AI and robotics further disrupting middle income jobs over the next decade. The trend to lower income jobs has been a drag on productivity and economic growth rates in the developed world.
At the same time the rich have been getting richer. The red line in Figure 15 shows that in the US the wealthiest 0.1% now control the same amount of wealth as the bottom 90% of the population (blue line). This increase in the wealth of a few combined with the weaker middle class is increasing social unrest and leading to populist politics.
The last time these lines were close was in 1920 and the 1930s, during this period radical politicians came to power. We are seeing an increase in radical and populist politics currently. These factors will be a drag on future economic growth.
Please note this trend towards income and wealth inequality is a natural function of a capitalist-based society. Over long periods of time the capitalists (those with capital) earn more income relative to workers (those without capital) because the former have two sources of income: (1) personal exertion; and (2) capital. The workers only have one source of income, personal exertion. The compounding effect of reinvestment of capital results in growing income and wealth inequality over time.
Figure 15: Wealth Inequity Has been Increasing
Another major headwind is climate change. Climate change is likely to be disruptive to the global economy over the next decade and beyond. Over 80% of the energy that powers the global economy comes from burning fossil fuels. Climate change is likely to result in flooding of populations, damage to infrastructure and disruption to food production. Figure 16 illustrates the strong correlation between economic growth and the increase in atmospheric carbon dioxide over time, while the graph in Figure 17 shows the strong association between rising carbon dioxide levels and global warming over time.
Figure 16: Economic Growth Increases carbon dioxide (CO2) in the atmosphere
Figure 17: Higher Levels of CO2 in the Atmosphere Leads to Global Warming
(vi) Investing in a low growth world
We have established the reasons why we face a structurally low growth world. In a low growth world, average quality businesses suffer more because they are reliant on economic growth for their own growth. In a low growth economy, average quality businesses can only grow their revenues organically in line with nominal rates of economic growth. Only superior businesses that can take market share can produce organic revenue growth materially above nominal GDP revenue. Operational leverage and financial leverage will turn negative. In a low growth world, competition will increase, the intrinsic value of average businesses is likely to decline, and value traps will become more widespread. The value anomaly is dead.
Investing in businesses/equities is primarily about achieving growth in real earnings over the holding period. Traditional value investing relies on both EPS growth and P/E expansion during the holding period. If the EPS growth is weak during the holding period, then the value investor is solely reliant for success on P/E expansion. The problem is that the terminal P/E is determined by confidence in future EPS growth. This assessment is partly influenced by historical performance because of recency biases and linear thinking. Thus, terminal P/E (the P/E when the investor sells) is heavily influenced by recent historical EPS growth. The two factors, historical EPS and terminal P/E, are positively associated with each other and self-reinforcing. During strong growth periods more average quality businesses do well in terms of EPS growth and this tends to support their market P/Es. During the six-decade “economic growth bubble” leading up to the GFC, average quality businesses reported strong EPS growth and thus because of this self-reinforcing relationship with terminal P/E resulted in the strong performance of value style investing. However, in the more competitive, lower growth environment since the GFC, average businesses have underperformed. Most businesses have been experiencing deteriorating economics since the GFC. The outlook for economic growth levels over the next decade is poor and deteriorating over time. Value investors almost exclusively buy average quality businesses. These businesses have worsening economics as shown by the trend to lower ROEs over the past 2-decades. Value investing does not perform if the earnings of these value type businesses deteriorate over the holding period. This is the dilemma that value investors face.
The “economic growth bubble” period that occurred in the six-decades leading up to the GFC is permanently gone and the value anomaly associated with this abnormal period in history has disappeared with it. The value style was highly successful in the high growth economic world (high nominal GDP growth economic environment) with low levels of competition and disruption, but in a low growth, highly competitive world value is unlikely to perform well.
Investors should focus on businesses and investment styles that are not reliant for success on high levels of economic growth and low levels of competition. Over the long-term the value of businesses reflects their real earnings and thus only companies that can grow their sustainable earnings will grow investor wealth. Quality styles of investing are likely to outperform in a low growth, low inflation and low interest rate world.
Mark Arnold (Managing Director and Chief Investment Officer) and Jason Orthman (Deputy Chief Investment Officer)
 Do Stocks Outperform Treasury Bills?, 2018 Bessembinder H, Arizona State University.
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