Value strikes back: How to manage style in your portfolio

-- | 18/05/2022

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Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport. Today joining us is Tim Murphy, he is the director on our manager research team. Tim, thanks very much for joining us.

Tim Murphy: Hi, Emma, good to be here.

Rapaport: Tim, I want to talk about this big value rotation that was seen in 2022. You know, I've been working here for a while. And the story has always been or since I've started here is growth, these growth funds have done really, really well, value has underperformed, and in the last quarter, we've seen a rotation in that. So can you explain quickly what value managers do and why they've come to the forefront in the last quarter.

Murphy: So in terms of investing style. So value managers are those that tend to focus, select stocks based on things like low P/Es, by dividend yields, these types of metrics, as opposed to growth managers that are trying to focus more on companies that have higher earnings growth or higher upside potential in future. And so if you think about what's driven markets for most of the last decade, it's that latter, many of those growth stocks. So thinking of the technology sector being the most obvious example, that has really driven stock markets right around the world, most notably in the U.S. where that obviously makes a big portion of their stock market, less so here in Australia, but obviously, there has been some big individual success stories on a smaller scale. Things like Afterpay for instance, obviously, people are familiar with. But you know, from an overall perspective, global growth as a style has been very much driving equity market returns for the last decade. Traditional value approach has definitely being—has underperformed and often been debated in recent years is value dead, it's certainly lots of…

Rapaport: And in that area, we're talking about energy, we're talking about…

Murphy: Yeah,traditional sectors, exactly right. Energy, financials being most notable, often consumer cyclicals, depending on where they're at in the cycle. So, dividend sectors are definitely well represented in the local Australian share market too. And so that's been a key reason in recent years, why the Australian share markets being one of the laggards globally compared to other markets offshore in particular, the U.S. as I touched on.

Rapaport: So we've seen value managers last few years saying it's going to come back like it's coming, it's coming, it's coming. And they've been, you know, wrong, except for last quarter. So do you think that they are somewhat vindicated now? Do you think they feel a sense of well, we were right the whole time?

Murphy: Yeah. I mean, I think there's a way for this to play out, right. And there's obviously a cycle still to play. And I think we're early days, I mean, one of the—the biggest thing underpinning this has been, the period of easy money. So, we've gone through multiple decades now of interest rates coming down. And we now seem to have seen the bottom of that cycle. And obviously now, just this week in Australia has seen first rate rise, and we've already seen that take place in other markets around the world. And so what that easy money has fuelled longer duration assets, and helped push up the price of stocks where people are chasing some of the higher growth opportunities. With that now reversing, that's having the opposite effect. And so that's why you've seen the much bigger sell off in a lot of the tech oriented names in particular. So if you look at the U.S., the NASDAQ is certainly much further off it's high than the broader S&P 500, for instance.

You know, locally, at the same time, as that's happened, you obviously got this inflationary scenario playing out and what's going on in the energy market, a variety of factors driving that, obviously the situation in Ukraine, with the war, they're obviously not helping that either. And so, with the big ramp up in prices there, you've seen there a big tailwind behind returns in the energy sector for the first time in over a decade. And so we've seen this big rotation, as you touched on, in a very short space of time where tech had been in favour, is now out of favour. And things like energy and financials, have been very much driving equity market returns in the last six months or so.

Rapaport: If you put your manager research hat on for a second, the performance of funds under coverage, under Morningstar's coverage, at least I've noticed in the last quarter is that the people over the last few years that have been at the bottom of the rankings have now flipped to the top and vice versa. Is that something that you're seeing across the whole equity sector.

Murphy: Yeah, we're seeing across the board? Because the drivers of returns have very much flipped on their head, as you said, last year's winners have quickly become this year's losers and vice versa. And so that's when if you think about our research process we don't, past performance isn't much of a contributor to how we think about things, we try and think about it through the cycle. And so while you're seeing this rapid rotation, who's winning and who's losing and relative performance, you don't see much change as a result of that in our actual ratings, where we're looking through a cycle about how value managers can play that, through the time, and similarly how growth managers can play that through time. Certainly in recent years, there's been lots of very high returning growth managers, which we haven't had the highest ratings on. And people may have questioned, but now looking at it this year. And many of those have suffered big drawdowns as we sit here right now.

Rapaport: Yeah. So let's talk about portfolio construction. Listening to this, somebody might say, okay, so growth is out, value is back in, maybe I should move all my money to value funds. And as a manager of portfolio, you actually employ both funds in your portfolio. So why do you diversify by factor, mix factors in a portfolio, rather than saying, okay, values in we're going to go all value.

Murphy: The ability to time entry and exit into the sort of styles are different factors. Very few people if anyone has the ability to consistently do that through a cycle. And so what we're trying to do when we build portfolios, and help people do that is not be overly reliant or overly exposed on any one approach. And so, when we pick, select different styles of managers to blend in a portfolio, we're taking different approaches, at any given point in time, some of them will be working, some of them won't be working. In fact, we often say to clients, if everything is sort of outperforming at once, then frankly, that's a bad portfolio, because you've clearly got risk correlated in the same area. And that can flip on its head. But obviously, through a cycle we're aiming for overall portfolio to outperform to relevant benchmark over that medium to longer term period.

Rapaport: And in the bond side of the portfolio—go away from equities and just focus on bonds, you're doing the same sorts of things in a high yielding environment.

Murphy: Yeah, exactly right. And so, you know, we've obviously seen a fairly rapid rise in bond yields, which has certainly caused some of the biggest drawdowns ever in various bond indices. So, on the conservative side of portfolios, that certainly got a lot of people asking questions. You know, we had been having more exposure to shorter duration funds within the defensive side of our portfolios in recent years, but certainly, in particular, in the last month or so many of the managers we've observed have been adding duration within the portfolios themselves, because they've seen such a rapid rise in those bond yields, they feel now the opportunity or the risk return within bond markets. Certainly, there's offering appropriate return for the risk that says that definitely obviously wasn't 12 months ago.

Rapaport: Great. Well, thank you so much for joining us today and giving your insights.

Murphy: Thanks, Emma.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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