Sensible investors know that, in the long run, value stocks deliver superior returns to growth stocks. Furthermore, as disciples of Benjamin Graham will tell you, companies that are acquired at lower valuation multiples have a built-in margin of safety. If this is the case, how can we explain why value investors have tripped up so often in recent years — losing money on cheap U.S. housing stocks and banks prior to the financial crisis, and more recently on mining and energy stocks bought at apparently low valuations?
There’s a simple answer. All these value traps experienced high levels of asset growth prior to their collapse. Investors that looked only at traditional valuation measures, such as price-to-book or price-to-earnings, and ignored changes in industry supply conditions have been blindsided.
Take U.S. homebuilders. Prior to the financial crisis, some well-known value investors, including Bill Miller of Legg Mason, piled into the sector. Valuations seemed attractive — by mid-2006, KB Home, a large homebuilder, was trading at 1.2 times book and nine times trailing earnings. Yet its stock subsequently lost 75 percent of its value, and its book value fell by even more.
The problem for the homebuilders is that they were caught up in the U.S. housing bubble, acquiring overpriced land for development and contributing to the massive oversupply of new homes. It took six years for the excess housing supply to burn off and for land valuations to stabilize. Investors that paid attention to asset growth among builders — KB Home, for instance, had compounded its book value at an annual rate of nearly 30 percent in the five years to mid-2006 — were alert to this potential trap.
More recently, mining and energy investors have suffered a similar fate. A few years back, mining companies looked cheap. At the end of 2011, the Bloomberg World Mining Index was trading at just over ten times trailing earnings and at around half its book multiple from before the crisis. Yet since that date the index is down by 58 percent. Some of the largest miners have been hit even harder, with Glencore falling by more than 70 percent.
Again the problem comes from changes on the supply side. As commodity prices soared in the previous decade, mining companies went on a massive spending spree. Mining industry capex rose from under $20 billion in 2002 to more than $140 billion in 2014, resulting in over $1 trillion invested during this period. The global supply of commodities has increased dramatically since 2002 — iron ore capacity has tripled. As China’s demand for commodities has weakened, miners find themselves saddled with excess capacity, write-offs and burdensome debts.
While value stocks in sectors that have seen massive expansion in investment have disappointed, growth stocks have outperformed. The MSCI Europe Growth Index has beaten its value counterpart by some 40 percentage points over the past decade. Marathon Asset Management, a London-based fund manager with $50 billion in assets, argues that the conventional value-growth dichotomy is false.
Businesses in sectors that have experienced rising levels of capex and supply — such as mining and energy — should be avoided even when they look cheap, according to Marathon. Conversely, growth stocks in businesses with strong competitive positions and disciplined capex are attractive provided they can maintain high returns on capital for longer than the market expects.
Marathon’s capital cycle approach is supported by data. Andrew Lapthorne, Société Générale’s quantitative strategist, finds that firms with the lowest asset growth (bottom decile) have returned nearly 12 percent annualized since 1990, more than twice as much as the highest-asset-growth stocks (top decile). Nobel Laureate Gene Fama and his colleague Ken French have recently drawn attention to the asset-growth anomaly — namely, that businesses that invest less than their peers have delivered superior returns.
Recent academic research suggests that stock markets with the highest asset growth have generally underperformed. This explains why China, where investment has hovered near 50 percent of GDP for several years, has proved so disappointing to equity investors.
Value investors famously believe in mean reversion, betting that cheap stocks will see their profitability rebound and that growth stocks will stumble. However, they tend to overlook that mean reversion is driven by changes in profitability, which in turn is determined by changes in industry supply conditions. Until investors wake up to this fact, they will find themselves stumbling from one value trap into another.
Edward Chancellor is a former member of Boston-based GMO ’s asset allocation team and the editor of Capital Returns: Investing Through the Capital Cycle, a collection of investment reports from Marathon Asset Management.
