Jay Feeney, chief investment officer at Boston Partners, explores value investing and questions about the persistence of the value premium. According to Jay, when value is out of favor, that’s not the time to lose your conviction in the investing style’s future potential. While the severity of value’s underperformance relative to growth has repeatedly challenged investor expectations in recent years, today’s extreme spreads in valuation between growth and value stocks suggest a rising probability of mean reversion.
John Bryson: Hello, and welcome to the portfolio intelligent podcast. I'm your host, John Bryson, Head of Investment Consulting at John Hancock Investment Management. The goal of this podcast is to help investment professionals deliver better outcomes for their clients and their practice. Topics we'll typically address include advisor business building ideas, capital market updates, the latest trends in portfolio construction, and unique investment insights from veteran managers across our global network. Today, June 29th, 2020, I'm joined by one of those steely veterans, Jay Feeney, Chief Executive Officer and Chief Investment Officer at Boston Partners, a 25 year old, $60 billion Value Shop headquartered here in Boston with offices around the globe. Jay was an instrumental founder of the Shop and its wellrespected value investment approach. Jay, welcome to the show.
Jay Feeney: Thanks, John. Good to be here.
John Bryson: So let's get into it. Tell us about how you define value at Boston Partners.
Jay Feeney: Well, I'd start off with the observation that I certainly don't think there's any necessity to redefine "value." I mean, typically, when you've had a long period of underperformance in any type of investment discipline, there's always an upwelling and an undercurrent. Some people are very vocal that they want to kind of redefine and will declare things obsolete. And I certainly don't see any evidence that there's a need to redefine the very traditional metrics that underscore value investing, and by that I mean, Peter Lynch famously said, "Earnings drive the market," and I'd remind our listeners that traditional value metrics based on earnings and cash flow are both theoretically and empirically and fundamentally what determine stock prices. We've certainly been in an environment particularly in the last three years where there's been a focus on other measures to define value, namely momentum and things like that. But we see no evidence whatsoever that, again, traditional multiples of earnings of cashflow, the sum of the parts of underlying businesses, we see no evidence that those aren't highly relevant in determining stock prices. So, again, I think traditional value metrics are still, always will, form the basis for fundamental valuation and the determinant of the long‐term direction of stock prices.
John Bryson: Okay. So we hear, in certain articles or certain broadcasts, there should be a value premium but it's no longer there. It's either washed out of the market because people have identified it and you can't really capitalize on it. What's your take on that?
Jay Feeney: Sure. I mean, the most famous measurements of the so‐called value premium I think at least academically speaking was Fama and French back in the early 1990s. There's been a lot of debate on the source of a value premium, and first I'd start with, there needs to be a recognition that a value premium isn't some consistent factor premium which consistently earns an excess return. The value premium varies over time, but over time, on average, it is positive. It is significant. We've clearly gone through a period recently, particularly in the last three years, where that value premium is quite negative. But we've been through this before, back in the 2000s. The 10 years leading up to the bursting of the internet bubble, the value premium was negative but it was quickly earned back and quite substantial surplus value premium in a very short order after the bursting of the bubble in the year 2000. So I think there's reams and reams of evidence pointing to the existence of a value premium and one of the more compelling observations that I've seen and heard is the existence of that premium and the excess return, again, over time, I clearly understand your listeners don't have infinite patience, few people in this world have infinite patience, but part of the reason you earn a value premium is because you do endure fairly lengthy periods of underperformance. We're clearly in the midst of that now. We were clearly in the midst of that in the 2000s leading up to the internet bubble which burst in March of 2000. But you get paid to endure these periods of underperformance. And I think the root cause of that really, I think some of the best explanations really, as many of the listeners know, is rooted in fear and greed and behavioral biases, that expectations, very high and very low expectations, are rarely met. Meaning high multiple growth stocks, which embed very, very high expectations of future earnings and sales growth are rarely met and very, very low and pessimistic explanations of value stocks meeting the expectations of value destruction, and declining earnings and sales—that's rarely met either. And so the source of much of the value premium really accrues to the latter, and a source of much of the failure of growth is based on that form or observation that super high expectations rarely come true and super low pessimistic expectations, similarly, rarely come true.
John Bryson: Do you feel that we're in a situation now where the optimistic expectations are so extreme that we're close to a turning point?
Jay Feeney: Well, look, I spoke at the summer sales meeting last year and some observations from some of the participants and attendees were like, "Jay always sounds the same. He sounds a little bit like a broken record." And, frankly, I view that as a compliment because in times like this when value is clearly out of favor you're really going to get punished if you lose your conviction and you change your stripes. So I can't call a turning point, and quite frankly, I'm surprised that we are now again, if you look over a 10‐year period, value's underperformed, but as I like to point out, in the aftermath of the financial crisis from '09 to 2016, value, I like to point out, was in a recession. Relative to growth value was experiencing recessionary conditions and kind of lumbering along and bleeding a little bit but still generating good returns. But in the last three years, value's really felt like it's gone into an outright depression in terms of the velocity of its underperformance or the severity of its underperformance relative to growth. So, frankly, and you mentioned the term turning point, and I've been surprised in many respects because here we are, we're back to a 10‐year period. But your question was, do you see evidence of these super high expectations? And we clearly do. I mean, right now we're at the point where value has underperformed growth to a degree which exceeds the bubble in 2000. You may recall, John, that back in the summer sales meeting last year I had asked the audience, how many of the attendees had been professionally active in the realm of investing during the internet bubble? And out of 100 plus attendees, if not more, you know the number, only a couple of hands went up. And so what we're seeing now is a large number of investment professionals really don't have that personal or professional perspective of having seen these exceedingly stretched valuations in the embodiment of super high expectations in security, because many of them are younger, certainly younger than me, and haven't been through it before. They're looking at some of these multiples and expectations and narratives surrounding these stocks and thinking it's normal and it's not. So there's ample evidence that the degree to which valuation multiples have been stretched for particularly a handful of technology and communication services. And you know who they are. There's ample evidence that they're embodying completely unrealistic expectations. Will they revert? Yeah, I'm quite confident they will revert. When will it revert? I can't call that. I read the same newspapers that you folks do and that's a speculative call. I think the investment call is that the probabilities are clearly stacked against the super high multiple stocks, which have derived the vast majority of their returns, excess returns, over value stocks in the last three years have been driven by multiple expansion rather than fundamental growth in earnings and cash flow.
John Bryson: It's interesting. You mentioned the internet bubble and I remember you asking that question that you did at our last sales meeting. And I think back to 1999, I was actually covering a value manager and he was an excellent value manager, well‐respected, and he finally quit because so many clients had bailed on him and he just kind of got tired of it. He was close to retirement anyways. I fear that we almost need a couple of really legendary value managers to quit and those will be the final death knell of the growth run and we'll go back to that period again, because I remember it in '99. I remember it again in 2008.
Jay Feeney: Well, John. John, it's not going to be us.
John Bryson: Excellent. Excellent.
Jay Feeney: Okay, I can guarantee you that. Now, interestingly, what I vividly remember, I think it was a cover of Barron's and even the cover of Time Magazine had these pictures of Warren Buffet more or less declaring him a dinosaur and obsolete, and that kind of marked the bottom. But you see some pretty well known hedge funds, it's tough on value managers. It's doubly tough on a lot of hedge funds who are long/short, because, face it, in general, most investors have a value bias. It's just a matter of degree and value. Their job is to go find undervalued stocks, and everybody has a different mechanism for their measurement of undervaluation or attractive valuation, so to speak. Hedge funds, on the other hand, they're short, the opposite characteristic. So they're getting doubly squeezed, and you've seen just tremendous numbers of hedge funds and very, very well‐known hedge funds shuttering their businesses and sending their capital back, which I think is clearly the lead indication of the stress in the investment and active management industry and it's palpable. I think you're right there, the frustration level and clients voting with their feet will tend to mark the bottom. There's always, in our own collective experience, Mark Donovan and Steve Pollack and Chris Hart and Josh White, who are part of our global team in discipline value and discipline mid‐cap value, we all in our collective experience have recollections of just very difficult situations where a client has fired us because their patience ran out and there's always one that marks the bottom of the cycle. And we're kind of seeing it now that when you get redemptions from your funds and things like that, it's, hey, look, it's a cyclical business and it's understandable but we're seeing signs now that people are not doing smart things. Because, remember, the golden rule in investing and in life in general is you buy things when they're on sale. Whether you're buying a house or you're buying an automobile or you're buying an investment product, you buy it when it's on sale. And when you look at the suite of disciplined value strategies, and I look at them both in relative and absolute multiples embedded in the probabilities that are embedded in these portfolios, I think you come to the conclusion that these things are on sale and clearly when people vote with their feet they're moving and buying financial products and competing strategies that are much more momentum driven. And it feels like where we're beginning to divine the depths of a bottom.
John Bryson: Gotcha. So one of the questions that I had lined up, and I think you've already answered it, it's really around, is value dead? Is mean reversion dead? And I'm hearing pretty loud and clear, "No, it's not. It's been a long stretch and it's usually a long stretch and a painful stretch, but there is light at the end of the tunnel." Is that a fair way to think of it?
Jay Feeney: Yeah, well, mean reversion is a very widely used term in financial economics and in academic literature in the realm of finance theory. I prefer to think of it a little bit differently. I prefer to think about it in terms of probability. I told you at the outset that I'd been revisiting and reading a couple of new Churchill books, he's a wildly entertaining character and there was a great quote that he had. His security staff used to get very nervous during the Blitz. He would go up on the roof of 10 Downing Street and watch where the Luftwaffe was bombing pieces of London and the security details were petrified that he was going to get hit with shrapnel. They said, "You can't do that." And he said, "I take refuge beneath the impenetrable arch of probability," which I think is a great reference for value managers. And I guess many years ago, I used to say, "I worship at the altar of mean reversion." But I think a more accurate descriptor is that we basically are in the business of probabilities and when you get to points where you have such extreme spreads in valuation between value and growth and you really begin to look at what probabilities are implied in those extreme valuations, you have to come to the conclusion that they're just really unrealistic on both sides, on both the probabilities embedded in the discounted valuations of the value cohort and then the exceedingly high expectations of in terms of earnings and sales growth embedded within much of the growth cohort. Again, so while you think about mean reversion, I encourage people to think about what kind of probabilities are truly embedded in the prices of these extreme valuations. And, ultimately, I think you have to come to the conclusion that they're simply not realistic on both ends and that's evidenced by these super wide valuation spreads, which are now at historical extremes. Again, not calling it a turning point but you're beginning to see all different types of connecting the dots. You'll see data points that are just beginning to point to a highly unsustainable situation.
John Bryson: Is there any other data points or catalysts that you're looking for that will, I would say, continue to give conviction that now's the time to kind of stick with it and keep holding on to your positions?
Jay Feeney: Well, look, I mean, the basis of any rational asset allocation framework has to be, again, diversification in balance. You're never supposed to have no growth in your portfolio. You're never supposed to have no value in your portfolio. And as I pointed out, the golden rule in life, again, whether you're buying a house or an automobile or investing in a financial strategy or product, is that you buy things when they're on sale. And I'm telling you, I mean, value is on sale. I've said it four different ways. I said it last summer. I certainly didn't foresee a global pandemic combined with a deterioration of global geopolitical relationships. Now we're in an election year as well, which creates another layer of uncertainty. And then you layer on a huge amount of civil unrest and near race riots, and you've got a recipe for uncertainty and people hiding and running for the high ground. And what do they do? They typically run to what's worked. They keep allocating to what's worked most recently as opposed to taking the plunge and investing in what's on sale. We all know that momentum has been the factor that's worked over the last three years in particular and even somewhat over a longer period. But based on the probabilities embedded in the valuations, which has underscored these momentum trades, it's really tough for me to see somebody being overallocated to growth at this stage of the game and not moving more aggressively into value‐based strategies.
John Bryson: Jay, it's wonderful to talk to you. I always learn something. I've got two closing questions. Tell us the name of that book again, and any other books that you would tell a true value investor, if they need a boost in spirit, what they should look for. And then you've been investing for 35 years, any final comments you'd leave for us?
Jay Feeney: Well, I mean, the Churchill book is The Splendid and the Vile. And truthfully, it's a very odd name and I don't know what the origin of that strange name is, but it's an easy read and it's a quick read and it's highly, highly both informative and entertaining. And, look, guilty as charged. I sound like a broken record. I understand any value investor's frustration in listening to, "Well, geez, you sound the same and it keeps going on." Look, there are a couple of things that I point to that I don't think are getting sufficient attention, and your listeners and you know we're bottom‐up stock pickers and we don't spend huge amounts of time on macroeconomic narratives. But if you look at the expansion of the money supply that has happened in the last two or three months at the behest of the Federal Reserve, any measure, M2, M3, broadly defined, you have this massive, massive expansion in the money supply. And the deflationary impulse, which happened right as the economy shut down, clearly, there was a deflationary impulse because the economy shut down and the consumer basically, forcibly had to completely shut down spending. That's ebbing and that's going away, but then you have to layer on a 25% to, in some measures, a 40% increase in the money supply. And the old quantity theory of money, MV equals PQ, money supply times the velocity of money is equal to inflation price level multiplied by the quantity of money, MV equals PQ made famous by Milton Friedman, there has been a massive expansion in the money supply and I think the odds and the probabilities point to an increase in inflation, an expansion, an increase in the level of interest rates, steepening in the yield curve, all of which are favorable and create a fairly significant headwind for value investment strategies. And when you really scratch and peel back the layers and you look at the size of the expansion of the money supply, it's really jaw‐dropping. So I'd encouraged people to take a look at that. It's just one factor. And then, as you know, growth stocks being long duration securities are clearly placed at a higher level of risk in a rising rate environment. So it's just one. Again, from a macro standpoint, it's one observation that I really just haven't seen much emphasis on and it's fairly mind‐boggling the degree to which the money supply and the inflationary pressure that that brings with it is in existence out there.
John Bryson: Without a doubt. Jay, like I said, it's always wonderful to talk to you. I always learn something new. I want to thank you for sharing your time today and sharing your insights. To our audience, if you want to hear more, please subscribe to Portfolio Intelligence on iTunes or visit our website jhinvestments.com to read more of our viewpoints on macro trends, portfolio construction techniques, business building ideas, and much, much more. Thanks for listening to the show.