It has now become a tradition for me to present the principles of value investing to students in Luxembourg, this year at the Luxembourg School of Business. The course is co-organized by the Luxembourg Value Investing Society ( LVIS ) and is taught by 2 university professors, Jos van Bommel for finance and Thomas Kaspereit for accounting, and myself. One objective of the course is to confront the academic and the practitioner’s views on value investing. In my part of the course, I explain how we screen for investment ideas at ECP with our quality/value framework, how we perform due diligence on individual companies, how we assess the earning power of a company, and ultimately how we come to our fair value.
With MSCI Europe Value having underperformed MSCI Europe Growth by 25% in one year, 40% over 3 years, and 45% over 5 years, I was expecting an empty audience at best and a value manager bashing session at worst. To my big surprise, I was wrong… we had 30 participants ( on-line and on-site ) and the dialogue showed sustained interest In value investing amongst the younger generation, the students.
Without going into the details of the course, here are 2 interesting take-aways. Thomas showed the below graph, putting in relation the number of active investors ( n ) and their alpha generation ( α ). The more stock-pickers there are the less ability they can generate outperformance. After commissions ( C ), mainly management fees and transaction costs, the picture is even worse and it becomes difficult to generate positive alpha. This is not new and not surprising as an analysis. What I find interesting is that we are on a journey where the number of active managers is decreasing rapidly due to the success of passive investing mainly through ETFs. Due to the underperformance of value, many value investors are quitting the space and their funds are being merged away. At the same time, commissions, both in trading and management fees, are decreasing in the industry as competitive pressure is high. So we are moving to the left side of the graph.
source: Thomas Kaspereit
Despite the underperformance of value since the financial crisis the long-term track record for value remains intact as can be seen in the below:
source: Longview Economics, Macrobond, Ibbotson & Associates. (*) Data merges indices from Ibbotson & Associates and MSCI.
There are in my opinion 2 additional readings in this graph: first the strong correlation between interest rates and the outperformance of value. In other words, we need interest rates to go up for a sustained rebound in value. Secondly, if underperformance of value becomes extreme like in 1999/2000 with the Internet bubble, the rebound of value is brutal and quick even without a fundamental change in the direction of interest rates.
My suspicion is that we are just at such a moment as underperformance of value has become extreme during the COVID pandemic.
For Value Managers who are able to convince their investors to stay put, I believe the rebound in value stocks could be of an epic dimension as its recent underperformance. It is indeed a very good moment to be price sensitive in investing: so the students are right to attend a course on value investing.