CONTRIBUTORS
James J. Clarke
Portfolio Manager & Director of Fundamental Research
At the core of our value investing philosophy is the concept of regression to the mean. Let us start by grounding that in some foundational economic concepts. We also will complement the explanation of regression to the mean as nature practices it.
At any time there are companies or industries earning substantially more or less than the economic norm. Similarly, there are always some countries where the currency makes goods very expensive in dollars and others very cheap. As equity investors, we look for companies that have been sold down to well below their intrinsic business value, and we have found them in just about every industry and country at one time or another.
These prices do not exist in isolation. They trigger economic responses. For example, that new industry earning 50% return on equity attracts competitors which ultimately bring down the return. A cheap currency brings tourism and investment to the country, creating demand for that currency. The company that is out of favor can get taken over, or replace its management, igniting change.
Countervailing economic forces bring extremes back into line. That is regression to the mean and that is how value investors typically make their money.
On the first page of Security Analysis, author Benjamin Graham, a Columbia University Classics professor turned hedge fund manager, quotes Horace “Many shall be restored that now are fallen, and many shall fall that are now in honor.” Value investors express that more simply through the old proverb “trees do not grow to the sky,” meaning there is an inherent limit to growth, otherwise known as regression to the mean.
Value investors struggle most when the opposite happens, when there seems to be no curb on growth or market forces. Those natural “self-correcting” forces become overwhelmed during periods when investors cannot get enough of the “good stuff” and will sell the “bad stuff” at any price. This is known in finance as momentum, when current period winners advance largely because they were winners in the past period. Momentum is certainly a countervailing factor in investing, but it is an emotional force, not an economic one. Momentum creates those overshoots in either direction, which value investors capitalize on by buying or avoiding. In moderation, it delivers actionable opportunity.
However, sometimes momentum in one direction is met by more and more momentum. Trees actually are growing to the sky. This phenomenon is rare in today’s US equity market as shown in the following chart from Empirical Research (see Exhibit 1).
The momentum factor in the US market has only been this strong two other times in the last 40 years. We last saw a similar magnitude of momentum performance in the bubble coming out of the COVID pandemic. The most striking example was 1999, which was far more extreme. Those were advantageous times to take the other side based on what happened subsequently, though painful to experience at the time from a value investor’s mindset.
However, it is not just a case of US stock market momentum. As global value investors we are facing headwinds on two fronts. In addition to a momentum frenzy, there is also an extreme gap between US and non-US. Not in the 30-year history of this data has there ever been a higher valuation premium for US stocks versus the rest of the world (see Exhibit 2).
That gap widened in the fourth quarter of 2024, specifically following the US presidential election. In a few days in November, investors responded to the election of President Trump by bidding up the US market further, by nearly 7%, while the rest of the world remained flat. Momentum, not value, drove the winners in the US.
As a global investment team, we have clearly been on the wrong side of momentum in the US, and with the US versus the rest of the world. However, verb tense matters since as investors we invest forward, not backward. A decision to invest today will be right or wrong based on future returns, not past. Currently, the most expensive country in the world—the US—is literally two-thirds of the MSCI ACWI Index. And that goes for the value index since the MSCI methodology pegs the country weight in the value index to the broad market.
Last year, 17 of the top 20 index contributors and a stunning 20 in the value index were all US companies (see Exhibit 3). We like the opportunity to invest against extremes and we are facing down two big ones right now.
These two trees—extreme US market momentum and the divergence between the US versus the rest of the world—have grown high into the sky, likely well beyond their natural limits. However, keeping with the tree analogy, how do trees grow? They grow a little bit each year, one ring at a time. It is a slow compounding process, fighting against the force of gravity. Then think about what happens when gravity wins and that tree falls. It happens very fast. Trees fall a lot faster than they grow. And that has been true of many market frenzies as well.
Index Definitions:
The MSCI ACWI Index captures large and mid-cap representation across developed markets and emerging markets countries. The index covers approximately 85% of the global investable equity opportunity set.
The MSCI ACWI Value Index captures large and mid-cap securities exhibiting overall value style characteristics across developed markets countries and emerging markets countries. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price, and dividend yield.
The S&P 500 Index is a broad measure of U.S. domestic large cap stocks. The 500 stocks in this capitalization-weighted index are chosen based on industry representation, liquidity, and stability.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.