Value Redefined?

Historically, a "value" manager was in a category that adhered to a numerical basis for the valuation of an investment. This process was typically balance sheet-driven in which assets were purchased for less than their valuation. The positive estimate between the value received and the price paid constituted a "margin of safety." The results were driven by downside protection and some percentage of upside capture.

In contrast, a "growth" manager was in a category that followed structural disciplines in which indicators of growth were identified. This indicators might vary from gaining market share from cost or disruptive technology all the way to simply price movements. The results were driven by capturing the gains of expansion followed by a quick exit if any signs of maturity or decline set in.

Seasonally, value and growth managers alternated leadership with the best in each category generating superior results to market averages. However, for the past ten years (excepting the past two quarters), "growth" has trounced "value." While many pundits argue for a "reversion to the mean," I think that something else may be at work. 

Generally speaking, an investment does well if there is scarcity of supply relative to demand. After the vigorous efforts to restore markets damaged by the Great Recession of 2008-9, capital became abundant. Rates were low. This trend accelerated during the Great Infection of 2020. With government fiscal spending and central bank monetary support strongly committed, this abundance of capital could thwart the "reversion to the mean" thesis.

Business cycles are characterized by cycles in profits. When profits sink, unproductive assets drop in value, capacity is closed and capital is withdrawn. Later when profits recover, capital flows back into assets, capacity is expanded and assets increase in value. Critical to this cycle is scarcity of capital. If capital is abundant, then as profits drop, capital is not withdrawn and capacity is not closed, but instead continues to compete at lower levels of profitability. As a result of capital abundance, industries may experience prolonged competition and a decreased ability to cyclically get to "the good old days."

If this is so, then "value" managers may still capture results numerically, but need to focus on income statement items in which reasonable assumptions of growth are secured by some durable competitive advantage. Durable competitive advantages offset the impact of capital abundance. By discounting future earnings of such companies at today's lowered rates, value managers may discover a "margin of safety" through growing earnings rather than recovering assets. Such an approach may not yield the same combination of downside protection and upside capture, but it may generate superior results due to owning assets less subject to commoditization.

The Eyes of the Market

The eyes of the market are focused on inflation. This is appropriate, given that a sustainable dynamic of inflation would completely change the current dynamics of our economy. The reasoning is simple. If the Federal Reserve removed inflation under Paul Volker's leadership in the early 80s by tightening rates and shrinking the Fed's balance sheet, why wouldn't the opposite actions do the opposite? With the Fed's balance sheet ballooning to nearly $8 trillion shouldn't we be concerned that a view of benign inflation is simply a form of "fighting the Fed"?

This reasoning process is sound but fails to take into account the asymmetrical impact that Fed support has. This impact has been called "pushing on a string," articulating the powerful nature of a string to restrain but its limitations to support. Fed policy is difficult to disentangle from the other powerful force of fiscal policy. To use a model of disentangling, look at the current situation in Europe.

The ECB’s benchmark deposit rate sits at minus 50 basis points, with the seventh anniversary of sub-zero borrowing costs coming up next month, while total assets on the ECB balance sheet were €7.6 trillion ($9.3 trillion) as of last week, equivalent to 57% of pre-pandemic nominal GDP in 2019.  That compares to $7.9 trillion in assets held by the Federal Reserve, equivalent to 37% of 2019 output. Here is a situation of more significant central bank support that is not muddied by the aggressive fiscal stimulus in the US.

Of course, inflation could rise on a sustainable level, but the Fed's role will not be key. The Fed's actions have provided liquidity to the markets as well as a valuation lift. Every asset owner has received a "stimulus check" in the form of this support. Clearly the Fed will withdraw this support at a future date, but not until other forces have successfully driven sustainable inflation. So far those forces seem temporary.