Overweight cheap asset classes and underweight expensive ones."
This strategy sounds simple, but it’s not. There are two big challenges:
1. It isn’t easy to catch turning points. “To unlock a valuation advantage, you need a catalyst,” That’s why our process incorporates fundamental, macroeconomic, and sentiment factors.
2. Secular changes can create "value traps”. For the last 20 years, relative to growth stocks, value stocks have gotten cheaper and cheaper... and cheaper. For investors who seek to make money from relative valuations reverting to the mean—which historically has tended to work over time and across asset class pairs (see references below)—that’s about as disheartening a chart as I’ve ever seen.
What has created this mother of all value traps?
In one word, technology.
In more words, corporate business models have shifted from investing in hard assets (property, plant, and equipment) to intangibles (Research & Development).
The breakthroughs from intangible investments have been highly disruptive to legacy business models.
“You need to incorporate innovation into classic macroeconomic theory. If the pace of innovation is increasing, it’s easier to be in growth stocks,” said a member of our Asset Allocation Committee.
Accounting practices have failed to keep pace with this shift. According to Lev and Srivastava (2002), growth companies—especially tech companies—that invest in intangibles have looked increasingly expensive due to decreases in three important metrics:
○ Book values: “A firm investing heavily in R&D, IT, brands, or business processes (e.g., customer recommendation algorithms), may appear to be an overvalued company... whereas in reality its valuation isn’t excessively high when book value is properly measured.”
○ Earnings: “Reported earnings of companies with increasing investments in intangibles are understated, due to the immediate expensing of intangibles, leading to overstated P/E ratios.”
○ Cash flows: “Cash flows [are also] calculated after the deduction of intangibles, and therefore, do not solve the accounting-deficiency discussed above.”
