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global defensive equities 

Value stocks: not always a bargain  

March 2019

Laurent Nguyen, Head of Global Defensive Equities, Gabriele Susinno, Senior Client Portfolio Manager

History shows 'value' stocks can deliver superior returns during an economic slowdown. But true value is hard to find. 

Value investing – buying stocks that trade at an attractive discount to a firm’s intrinsic value – is one of the oldest equity investment strategies, pioneered in 1930s by the renowned British-American investor Benjamin Graham, a mentor to Warren Buffett.

Yet despite its pedigree, its reputation has taken a hit in the past decade. In that time, value stocks have endured their worst performance on record compared with their growth counterparts – those firms whose earnings are expected to grow rapidly (Fig. 1).

In recent months, however, value stocks have witnessed something of a revival as a slowdown in the world economy has raised doubts over “growth” companies’ ability to deliver a sustained expansion in profits. This pattern is in keeping with the historical trend – experience shows value stocks tend to outperform in periods when the economy is experiencing a slowdown in growth.1

Fig. 1 A complicated relationship
MSCI Growth and Value index performance, indexed
MSCI Growth and Value index performance
Source: Bloomberg, data covering period 31.12 2008 - 07.03.2019

At first glance, then, it would appear that the conditions are in place for value to outpace growth.

But it’s not quite that simple. While growth stocks are, we believe, likely to suffer as the economy and corporate earnings growth both slow in the coming years – globally, company profits are expected to rise at about 5 per cent this year compared to 14 per cent in 2018 – their cheaper brethren aren’t necessarily the bargains they appear to be. Investors looking for value need to be far more discerning. 

Avoiding a value trap

Finding a genuinely cheap company isn’t easy.

This is because stock prices can deviate significantly from a firm’s underlying value, and sometimes for a very long period of time. Further complicating matters is that popular valuation metrics such as the price-earnings (P/E) ratio, price-to-book ratio or dividend yield don’t always paint an accurate picture.

They can easily be distorted by corporate activities such as mergers and acquisitions (M&A) and share buybacks.

That’s especially the case today. M&A volumes have hit record levels, with deals worth nearly USD3.3 trillion agreed globally in the first nine months of 2018 – a 39 per cent jump from the year before. Stock repurchases, meanwhile, are also at historic highs in the US. 

Popular valuation metrics such as the price earnings ratio don’t always paint an accurate picture.

Pitfalls of an index

Using our proprietary 4-P quantitative investment screening model (detailed in Fig. 3), we find that an unusually large number of stocks that make up the most popular 'value' equity index could be cheap for a reason.  

Our analysis of the returns of stocks within the MSCI Value Index shows that companies that rank in the top quintile of our proprietary scorecard have outperformed both the index and those in the bottom-scoring quintile since 2000 by a significant margin (Fig. 2). This points to a material difference in the fundamentals of companies whose stocks come under the 'value' label. It's a red flag 'value-oriented' investors shouldn't ignore. 

fig. 2 true value vs junk value

Cumulative performance of different groups of value stocks

Cumulative performance of different groups of value stocks
* Cap-weighted proxy of MSCI Value Index. Value quintile groups refer to the top or bottom 20 per cent of stocks in the proxy MSCI Value Index as ranked by equally-weighted 4P screen. Source: Pictet Asset Management, Bloomberg, data covering period 03.01.2000 - 04.03.2019

Using value as part of defensive shield

Our 4-P model - the bedrock of our Global Defensive Equities strategy - is designed to identify stocks that can deliver better returns than world equity markets over a full economic cycle and, crucially, also protect capital in a downturn.

Value (Price) is one of the components. The Price screen is designed to ensure we don’t overpay for our investments. It incorporates not only the popular valuation metrics such as the price to book ratio, but also other useful fundamental value indicators based on Enterprise Value, which is a comprehensive measure of a company’s total value using market capitalisation, long-term debt and cash on the balance sheet.

We combine Price with three other factors – Profitability, Prudence and Protection (see Fig. 3).

Fig. 3 4P, a multi-dimensional framework
Pictet 4P framework
Source: Pictet Asset Management

Each of the 4Ps is part of a defensive shield, which produces an equity portfolio that is designed to be better able to withstand market shocks.

Our 4P framework is dynamic, not static, as many smart beta strategies tend to be. Our starting point is to evenly weight all the 4Ps when we screen stocks. We then modify that allocation, basing our decisions on an analysis of economic and market trends and the momentum and valuation of each P.

We are currently overweight the Price metric, which means that many of the companies we hold in our portfolio score strongest on the valuation measures; these stocks concentrated in sectors such as consumer staples, financials and industrials. 

In other words, as the longest bull market on record shows signs of ageing,  our model helps us avoid not only  overpriced 'growth' stocks, but overpriced 'value' stocks too. 

Just as Buffett said: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”