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