US value: Embracing the uncertainty you can’t escape

Key takeaways

• The challenge for value-disciplined investors is that long-term winning often comes with short-term losing, and navigating it is a critical part of our investment process.
• Given extreme levels of concentration and historically low levels of volatility, as long-term investors, we are well-positioned to adapt to surprises that would wake a complacent market.  

Market overview

In a recent commencement speech, eight-time Wimbledon champion Roger Federer noted that despite winning almost 80% of his 1,526 matches, he only won 54% of the points. His message is powerful: perfection is impossible, and that after each point you must quickly learn and then move on, “because it frees you to fully commit to the next point and the next point after that, with intensity, clarity, and focus.” Federer’s true strength was overcoming short-term noise and setbacks to remain focused on the long-term signal of winning.

Value investors may take some solace in Federer’s insight as value stocks have recently lost a couple points to a highly concentrated market favoring growth stocks.

As long-term investors, our goal is naturally to win over the long run, and specifically with investments where the probability of winning increases materially as a function of time. The challenge is that long-term winning often comes with short-term losing, and enduring and navigating it is a critical part of our investment process. The key is knowing what to ignore and what to pay attention to, and we categorize losing into two clusters: what we call noise losing and signal losing.

This short-term pain, long-term gain tradeoff is an almost inescapable challenge for valuation-disciplined investors. In fact, valuations, evaluated over a one-year time horizon, can have zero or even negative correlation with relative performance (Exhibit 1). As such, the valuation seeds we plant in any given year typically take at least two to three years to bear any fruit. This forces us to recognize that some level of short-term losing is inescapable, and, in most cases, we should ignore short-term variance in relative performance. This requires the emotional resilience to endure and stay focused on the process, which we have done for over 30 years. Having the grit to look through daily noise, however, must be balanced with the intellectual honesty to constantly look for signals in the losing. Achieving this balance is one of the critical arts of successful investing.

The power of our investment cases is that they are falsifiable, or able to be proven wrong. They lay out exactly what we are looking for if we are getting the fundamentals right and, conversely, allow us to falsify the investment case when we are getting the fundamentals wrong. For example, if a stock is underperforming but the investment case is still on track, we will stick with it through the noise. If the investment case gets falsified, we will sell. In some rare cases we get lucky, and a stock will start working even as the investment case falls apart. We sell those cases too, as the signal comes from watching the fundamentals.

Another critical element of our stock-level process is that we are looking for attractive risk-reward, with much more upside when we are right than downside when we are wrong. This allows us to make mistakes, learn and move on without sacrificing long-term performance. In addition, most of the stocks we buy are generating healthy free cash flow and reinvesting at attractive returns or returning the cash through dividends and buybacks. This allows their intrinsic business value to compound higher while we wait for price to converge with value, and it often allows us to harvest a healthy dividend and buyback yield while we wait. Finally, we are targeting a much bigger payoff if fundamentals end up exceeding our base case. What we have observed is that when things start getting better, they often get surprisingly better. This gives us a potential right tail of returns that we do not have to pay for when we originally invest, and an incredibly attractive risk-reward when our bull case materializes. The opposite is also true, which is why our sell discipline is so critical.

Portfolio construction is another layer that helps us filter through short-term noise. If value is about the tradeoff between short-term losing and long-term winning, then price momentum is the tradeoff between short-term winning and long-term losing. While we are always overweight value, we typically diversify this with also being overweight price momentum. Due to the different tradeoffs inherent in these two factor exposures, the resulting mixture is one of the best portfolio construction tools in our arsenal. The key is that we source our price momentum when our value investments start bearing fruit from price and value convergence, driven by better-than-expected fundamentals. This gives us a greater risk budget to layer into short-term losers and has made us much more patient in selling our winners.

The other portfolio construction signal we watch for is when we start losing relative performance in magnitude and duration, which suggests a shift beyond normal market noise. These shifts are often characterized by big spikes in market volatility and correlations that generate portfolio downside capture above a level we are comfortable with. Managing this process provides us with a dynamic risk budget that we try to stay ahead of.

Against the backdrop of this process, today we note that market volatility and correlations are near historic lows, suggesting a substantial risk budget. However, risk premiums and valuation spreads are also low, which has us increasingly positioning for an eventual shift in the current market calm.

Embracing the uncertainty you can’t escape

Most investors hate uncertainty and, in many cases, engage in what we call “uncertainty laundering,” which is pretending it does not exist. However, we choose to embrace the inescapable impact of uncertainty. This forces us to think creatively and probabilistically about potential futures and where surprise could lead to potentially high returns. Our goal is to position the portfolio to be resilient across as many scenarios as possible, which allows good outcomes to become great outcomes over time. Like Federer, our focus is on playing the long game by managing the short game to the best of our abilities.

The biggest change during the second quarter was that inflation risks declined modestly on better inflation readings, setting up the possibility of monetary easing late in the year. This led us to entertain several market scenarios around a first rate cut that we do not think are fully priced into the market. Given historically low volatility, markets seem very comfortable with simply extrapolating the current dominance of mega-cap tech stocks most closely tied to artificial intelligence (AI). As investors, we are much more diversified than the current market as we are positioning for two potential surprises.

1. The first surprise would be that Federal Reserve (Fed) easing allows the market to broaden out from its current, extremely concentrated perch. We think this is the more logical outcome and is our preferred one. Monetary tightening has favored the cash-rich and secular growth of the mega-cap tech companies, while squeezing many smaller cyclical companies, especially ones with debt. With market breadth near historic lows and a tendency to mean revert (Exhibit 2), why wouldn’t the great relative relief of a Fed ease trigger a broader market? This is our preferred outcome because we are finding the combination of attractive valuations and good fundamentals that we look for in large, rather than mega cap, stocks. In a world where investors are crowding into the same few stocks, this is a differentiated, active size bet that we are getting paid to take. We have found that even when people correctly forecast a macro change, like a Fed easing, they atypically get surprised by how the market reacts, as macro-to-micro translations are extremely challenging to predict. This surprise should work in our favor.

2. If the first scenario is what we are rooting for, the second is what we are preparing for, as one of our strengths is accepting the potential for negative surprises. There are increasing signs that monetary tightening is squeezing lower-end consumers and hurting cyclical, rate-sensitive sectors like housing. While not dire at this stage, they suggest moderate economic slowing. 
   
   However, monetary tightening has historically worked with long lags, and we think there is a rising probability that a Fed easing cycle could begin as evidence of a harder economic landing mounts.