The capital cycle in investing

Cycles are caused by human nature.

Howard Marks’ latest book focuses on them and is immensely instructive in helping an investor to think constantly about cycles.

Imagine two assets – “A”, and “B”. Investors start to prefer A, perhaps because the government has given a favourable tax environment, or because A is growing earnings slightly faster.

As early investors start to push the price up, the outperformance of A attracts the interest of short-term investors, and momentum traders. They justify its price rise and the reasons for it, extrapolating them into the future, and also invest.

By this point the trend is established enough to attract the interest of medium- and long-term investors, momentum ETFs and the rest. Retail investors are the last to join the party, as ever.

Asset A has outperformed and thus attracted capital incrementally.

The first level thinker says – asset A has done well for a decade, so it will continue to do well, I’ll buy some.

The second level think thinks – everyone already likes A way more than B, so there is a greater chance of B being undervalued relative to A.

The second level thinker can see that the success of a system (growth investing) automatically causes it to develop the very internal contradictions and weaknesses which will eventually bring about its failure.

That is, higher levels of competition and overvaluation.

Howard Marks writes, “outperformance is just another word for one thing appreciating relative to another. And, clearly, that can’t go on forever, regardless of how great its merit can be.”

Asset A cannot be infinitely more valuable than B, and there has to be a point at which A becomes overvalued relative to B. Soon the time will come for A to outperform B once more.

Markets reflect human nature as much as they do an objective investment reality. They are a swinging pendulum, moving from excess on one side, to excess on the other.

Hence the famous 13 August 1979 BusinessWeek cover:

Source: FT Alphaville

It proclaimed the death of equities for reasons like: millions of people giving up on equities, pension funds turning towards commodities and precious metals, underperformance relative to other assets, and inflation sapping corporate growth.

It just happened to do so on the eve of the greatest bull market in history, whether you include the run-up to 2020 or not.

Understanding the cyclicality of all things in investing and trying to figure out where we are in the current ones is pretty much the mission statement of this newsletter.

One major cycle, which is starting to receive some proper airtime at the moment, is “value investing”.

See the below chart, which shows value underperforming (trending down) relative to growth, based on price-to-book valuation multiples, since 2008.

Source: Bloomberg

In my mind there is no stronger reason for the resurgence of “value” investing than what I’ve already outlined about human nature, and cyclicality.

Markets move in cycles, and the value of value (what it costs to buy value stocks relative to growth stocks) is nearly at all-time lows, after one of its longest ever periods of underperformance.

In such a situation, the probability of outsized returns does not come from the standard position of all investors – buying US indices and FAANG stocks – but from the unloved, the undervalued, the underappreciated value stocks.

This is the capital cycle, but in investment.

We saw it in our book review last Friday and in last Wednesday’s look at the UK restaurant sector, and it is visible in investing too.

Growth investing started to go well. It attracted more capital. Soon private equity started to ramp up its investment in growth stocks – mainly tech. Then venture capital started to do the same at an even earlier stage.

Retail investors have become enamoured with big names like Tesla, Beyond Meat, cannabis stocks… all of which have highly stretched valuations considering their underlying financial performance.

Investors – both retail and institutional – start to see the momentum and pile in, in ever larger numbers.

New metrics are used, new excuses found for the extended run of growth stock darlings.

Meanwhile, value companies languish, relative to growth.

And now there is a new sport, which is bottom spotting. No, not like that. Trying to pick the bottom in the value to growth trend, which will signal the start of an incredible surge in value investments.

Because… well, what’s the opposite of “the higher the pedestal, the farther the fall…”

“Extremity breeds extremity” perhaps? The point is, the value of value is particularly low right now. It’s not a mild underperformance, it’s record breaking.

And so, with a bit of Newtonian physics (each force is met by an equal and opposite reaction) and an understanding of human nature, we can say with a reasonable degree of confidence that a return of value’s primacy will see a long and powerful uptrend to match.

Last week, value fought back briefly, and this coincided with an increasing amount of chat and research crossing my path about a potential resurgence in value stocks.

There was this, from AQR, which showed how the value of value is the most extreme it has ever been, whether you split it by industry, exclude main offenders (FAANGs), use different metrics or multi-factor analysis.

The expensive stocks are sometimes only <4x as expensive as the cheap stocks, the median is that they are 5.4x more expensive, but today they are almost 12x more expensive. For those first-time listeners, 12x is a lot! In fact, it is now (as of March 31, 2020) at the 100th percentile vs. the 50+ years of history we have.

It concludes,

Value is simply exceptionally cheap any way you slice it and any way you try to reduce it by excluding whomever you think the culprits may be. In fact, it’s record-cheap on what we think are common methods many quants use and usually by a decent margin.

Value stocks are supposed to be cheaper because they have lower return on equity (a common profitability metric). But return on equity (ROE) hasn’t deteriorated for the value stocks relative to higher-earning growth stocks – in fact it’s pretty much level for the last decade.

So the theoretical premium for growth stocks based on higher earnings growth is what’s been getting more and more expensive, not the earnings themselves. That suggests that it’s a divergence in investor sentiment, rather than a divergence in actual corporate performance that’s driving growth’s extended outperformance.

Basically, systematic profitability differences are simply not driving today’s super-wide valuation differences.

Finally, the author concludes:

Investors are simply paying way more than usual for the stocks they love versus the ones they hate (and measured using our most realistic implementation, this is the clear maximum they’ve ever paid).

I mean, you don’t need Occam’s razor here to prefer the simplest explanation – that there’s a very large mispricing going on right now throughout the cross-section of stocks.

It’s interesting to note that 20 years ago almost to the day, the same author made the same point in an article for the same firm – AQR.

Back then, he made three points:

  • Investors understand and are now comfortable with a very low expected return on the stock market going forward.
  • We are in for an exceptionally long period of exceptionally high growth in real earnings that justifies today’s market prices.
  • Most investors are not really thinking about either 1) or 2), but have swallowed the hype and slogans, focused on irrelevant short-term stories, or forced to be in stocks by circumstance (e.g., many mutual fund managers). All this is coming together causing a massive financial bubble. If true, it can only end with a tremendous market crash, or a very long period of stagnation.

And he called it about right – value surged from the year 2000, as you can see from the above historical chart.

To me, looking not at the extremely high valuations of stockmarket darlings, but at the good but undervalued stocks, is the more sensible strategy today.

But it’s no guarantee, annoyingly.

Howard Marks said something in an interview recently like:

“Extremes in the cycles affect the probability of returns, nothing more.”


“Probability is nice, but it isn’t everything, and it isn’t a timing aid.”


“Low valuations do not guarantee higher returns, but it does make them much more likely.”

A value approach may offer higher probability of outsized returns based on an understanding of market cycles, but that does not mean the strategy will make money in 2020.

But in a world of uncertainty, having the odds on your side is the best you can hope for.

And if you’re looking for value, one country in particular could be worth your time, as most people have shunned it for so long.

Take a look at Japan’s growth-to-value chart:

Source: Orbis

That’s all from me today,

Hope you all have a great week. Bit scary what’s happening over in the US, isn’t it! It’s in no way my area of expertise.

It just strikes me that as the US bails out investors and corporate management again, unemployment breaks records, race riots spread across the land and the president encourages state governors to “come down hard” on the “bad people”, that the US may be voluntarily abdicating its throne as leader of the free world.

There is so much good there too, but I fear for it.

Market cycles affect nations too. Success and outperformance on the global stage lead to complacency and stagnation, while others reform and strive for greatness.

Warren Buffett’s mantra of “don’t bet against America” cannot be true forever.

But I do hope its time is not yet over.

Best wishes to you all,

Kit Winder
Editor, UK Uncensored

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