Quarterly Letter

“It’s the end of the world as we know it, and I feel fine.”

- E.M.

Value investing is under attack. The US equity market is at its most expensive level in history1 and has spent most of the past six years in the top quintile of expensive.2 In addition, value equities have underperformed the broad market and more widely growth equities for over ten years. Yet, value investing is a principle-based process backed by well over one hundred years of empirical data and sound logic. The style has gone through fallow periods before, but the current famine is surely one of the longest. Still, we remain confident that value investing’s principles are eternal and they will prove so as the current cycle turns – whenever that may be. Nonetheless, we recognize the length of the current cycle makes what is always a difficult process to maintain almost untenable. This has led us on a multi-year quest to refine our own value-oriented process to become more robust and open to a greater breadth of environments while maintaining the core of the value framework.

We spent the bulk of our last quarterly letter3 discussing the very real link between asset class valuations and prospective returns. It is a familiar topic in these communications the past few years. Some might say we beat the horse dead many letters back. Yet, it is critically important. While valuation provides no indication of asset class return over the next 1, 3, or even 5 years, it becomes exceedingly explanatory over 7, 10, and 12-year periods.

As a reminder, by some measures (price to sales), the S&P 500 is more expensive now than it has ever been in measured history, and thus prospective returns are very low. As of September 30, 2017, GMO forecasts a -4.1% annualized real return for large capitalization US equities over the next 7 years!4 To put this in perspective, if the forecast is correct and you invested $1000 in large capitalization US equities today, you would have approximately $750 in 2017 dollars towards the end of 2024.

With that brief reminder concerning the broad US equity market, this quarter we are going to discuss portfolio construction a level or two below the asset allocation decision. Once we decide to allocate to equities (for example), we need to decide which equities. For Grey Owl Capital Management, just as we focus on valuation at the asset class level, we focus too on valuation at the individual security level. Rather than buy a broad equity index, we aim to buy equities that afford a value orientation (i.e. are “cheap” and offer a “margin of safety”).

The historical record demonstrates that moderating exposure to broad asset classes (e.g. US equities) as they become more expensive and, within asset classes (e.g. US equities), focusing on those securities that are statistically “cheap” works. These tactics have improved returns and limited downside volatility for the last one hundred years of available data. Unfortunately, improved performance comes with a cost, one we are all quite familiar with today. The trade-off or cost to employing these value-tactics is that they can underperform fully invested equity indices for multiple years at a time. And, for the last several years, they have.

Is Value Investing Dead?

“Is Value Investing Dead? It Depends on How You Measure It.” That was the title of the September 24, 2017 Wall Street Journal blog, The Experts, Wealth Management.