Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 240

At the start of 2018, I began to question value investing …

As the share market continued its relentless climb in early 2018, with minimal volatility, value investing was relegated to history as an anachronism from a simpler and more innocent time. Observing fund manager peers generating high double digit returns from companies whose prices weren’t even in the same universe as our valuations, I began to question the relevance of value investing myself.

Value versus momentum

However, a conversation with one peer cemented my loyalty to value investing, despite its inferior recent performance compared with momentum and growth styles. I asked my friend why he purchased a certain company given its high price. He said that my ‘problem’ was “too much focus on value and too little focus on business momentum". Apparently, it was fine picking a business with strong sales or subscriber momentum in the knowledge that as the growth continued and the story spread, other investors would join the party at higher prices and a profit could be realised.

He had made a substantial return buying stocks this way, but my next question revealed a flaw. I asked: “If you are buying well above a conservative estimate of value, how do you know when to exit?” His answer left me uncomfortable: “That’s a good question, you’ll see it ‘rolling over’.”

He meant that when the price momentum starts to slow, the price will gently 'roll over' and that would be his sell signal. If only the market were always so kind. Prices can drop sharply without warning.

Within a week, the Dow Jones Index lost 4% in a single day and at one stage was down 10%. The financial media produced some of the most breathless headlines seen in years. Many of my friend’s stocks fell as much as 16% in a few days. I wondered whether those falls constituted a ‘rolling over’ by his definition.

Jumping aboard the fads

How can a value investor win when there is nothing cheap enough to buy? The value investor holds funds in the safety of cash and watches as prices rise inexorably higher. When the optimists are winning, as they have been recently, value investing can’t hope to beat buying the ‘concepts’ that are going up the fastest.

It’s easier to join the party and buy the latest theme, fad or concept, partly because commentary surrounding the companies usually supports the rises with what appears to be entirely valid theses.

In recent months, and reminiscent of the dotcom boom, we have seen companies simply change their name or strategic focus towards blockchain, and the market has rewarded incumbent shareholders with 300% plus gains.

For example, on 21 December 2017, the Hicksville, New York-based Long Island Iced Tea company announced a “Corporate focus shift towards opportunities strategic to blockchain technologies.” The loss-making company’s shares rallied from just under US$3 to over US$15 during the day of the announcement. At their peak, the shares were trading 411% higher than their lows only a week or two earlier.

On 9 January 2018, Kodak jumped on the buzzword and launched its own cryptocurrency, KodakCoins, which are tokens for use in the blockchain-powered KodakOne photography rights management platform. Within days, Kodak’s shares were trading 390% higher.

Then eCigarette company Vapetek changed its name to Nodechain and said it would ‘explore’ Bitcoin, Ethereum, and other cryptocurrencies. The thinly traded shares jumped 360%.

These name or business changes are reminiscent of the adoption of those ending with ‘.com’ during the tech boom of 1999 and early 2000. Back then, investors mistakenly believed that new technology - technology that admittedly changed the world - would render all companies involved profitable. It is a common mistake.

Australia is far from immune from this irrational exuberance. Perfectly valid arguments are being proffered for companies with revenues of barely $1 million and market capitalisations of $1 billion.

High likelihood of poor future returns

There is no question the US market is expensive. The CAPE ratio sits at 33 times the 10-year cyclically-adjusted earnings for the S&P500. I know the CAPE ratio includes the negative earnings of the December quarter 2008, but a simple calculation that grows this year’s earnings by as much as 10% and drops out the 2008 number reveals the CAPE ratio is still at 30 times. It is higher than at any time since the 1800’s with the exception of the tech boom.

Robert Shiller himself warns that the CAPE ratio does a relatively poor job of predicting corrections, but it does an excellent job of predicting future returns. The aphorism ‘the higher the price you pay, the lower your return’ sits well with Shiller’s findings. With the CAPE ratio at record highs, we could see future returns at unappealing low single digits for many years.

What about volatility? The S&P500’s Sharpe Ratio (generally, a measure of risk-adjusted returns) is at near-record highs and at a level history shows has never been sustained. Even if the overvaluation doesn’t lead to a correction, volatility is likely to pick up. And if heightened volatility is a risk, and prospective returns are in the low single digits, the returns offered by cash offer a superior risk-adjusted alternative.

For Australian investors, while the domestic market might not seem as expensive as US indices, you can be sure of a high correlation if the US market turns down.

Timing is uncertain

I do not know with any useful accuracy when the US market will turn down more meaningfully than it did last week, but we do know some things:

  • There is little absolute value available in the Australian market for quality companies.
  • Irrational exuberance has emerged in some pockets of the market.
  • Ultra-low volatility and ultra-high returns (the S&P500 rose almost 20% in just the six months to December 2017) are not a combination that lasts very long.
  • Market corrections are usually preceded by the types of ‘shots-across-the-bow’ that we have just witnessed.
  • On a risk-adjusted basis, there may be more attractive alternatives to being fully-invested in equities.
  • History allows the recent weakness to be completely reversed and then replaced by another wildly bullish rally that sees caution thrown to the wind again and irrational exuberance itself making headlines.

On balance, caution is more appropriate than it has been at any time since 2009. Howard Marks, founder of the $100 billion Oaktree Capital, recently told clients to stay "defensive or cautious". Robert Shiller has warned "People should be cautious now." Both investors also said its not appropriate to be out of the market altogether. Our own process has arrived at a rising cash weighting but we’re still 70-75% invested. So, you could say we agree.

But we’ll leave momentum investing to those who believe they can pick the top.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is general information and does not consider the circumstances of any individual.

 

  •   15 February 2018
  • 3
  •      
  •   

RELATED ARTICLES

Forget picking the bottom and focus on value

If I get kicked out of the value investors’ club, so be it

Global search for short-term losers and long-term winners

banner

Most viewed in recent weeks

Why have Australian living standards 'fallen' and how do we fix it?

For the last few years there has been much talk of a 'cost-of-living' crisis in Australia and of 'falling living standards'. Lately this has flared up again with the pickup in inflation resulting in a renewed fall in real wages.

Will you run out of money in retirement?

Fear of running out has become a defining retirement anxiety. Why do some retirees die with substantial wealth while others deplete their nest egg? Evidence suggests the answer is more complicated than we think. 

Four options for an income investor’s next dollar

What if Australia’s golden age of dividends is ending? Rather than overhaul your portfolio, it may be worth considering where new capital can work harder. I discuss four income strategies and the trade-offs behind each.

The investment that sidesteps the new tax traps

Tax rules have changed, but many investors are still using yesterday’s strategies. Insurance bonds may offer advantages for those seeking greater control, tax efficiency and certainty about their wealth.

Why spending more in early retirement can improve lifetime income

Conventional wisdom encourages retirees to preserve superannuation. But if those likely to qualify for the Age Pension later in life spend a little more today, it may deliver higher lifetime income and a more stable retirement.

Testamentary trusts have secured the CGT exemption

Treasury’s latest CGT reform draft delivers a win for testamentary trusts and deceased estates, exempting estate-derived gains from the 30% floor. However, questions on death and divorce rollovers remain unresolved.

Latest Updates

Retirement

Why spending more in early retirement can improve lifetime income

Conventional wisdom encourages retirees to preserve superannuation. But if those likely to qualify for the Age Pension later in life spend a little more today, it may deliver higher lifetime income and a more stable retirement.

SMSF strategies

Who really loses from the SMSF borrowing ban?

The ban on borrowing to buy residential property inside a self-managed super fund was framed as closing a loophole for the wealthy. Yet ATO data suggests its effects may be felt more heavily on members with moderate balances.

Investment strategies

The investing rule that explains the next market crash

What if investment success depends less on picking the right assets and more on understanding the decisions of other investors? A principle borrowed from game theory offers a different perspective on markets.

Investment strategies

Gold: should you own the metal or the miners?

Gold is back in the headlines but investors may be asking the wrong question. Before deciding where prices are headed next, it's worth considering whether the investment you choose will deliver the outcome you're actually seeking.

Fixed interest

Global bonds markets are hiccupping

For decades, investors looked the other way as government debt ballooned. But a reckoning may be beginning. Bond markets are stirring and the consequences could reach far beyond markets into everyday life.

Property

Why investors are looking beyond traditional property sectors

A little-known corner of the property market may be quietly benefiting from powerful demographic and healthcare trends. Could this specialised sector offer investors something increasingly difficult to find: enduring demand?

Retirement

Retirement in reality - 6 months in

Is retirement really an identity crisis, or is something else at play? New insights challenge conventional thinking and reveal why some retirees struggle to fully embrace life after work.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.