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.

 

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

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Latest Updates

Investment strategies

Trump's US dollar assault is fuelling CBA's rise

Australian-based investors have been perplexed by the steep rise in CBA's share price But it's becoming clear that US funds are buying into our largest bank as a hedge against potential QE and further falls in the US dollar.

Investment strategies

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Property

Soaring house prices may be locking people into marriages

Soaring house prices are deepening Australia's cost of living crisis - and possibly distorting marriage decisions. New research links unexpected price changes to whether couples separate or silently struggle together.

Investment strategies

Google is facing 'the innovator's dilemma'

Artificial intelligence is forcing Google to rethink search - and its future. As usage shifts and rivals close in, will it adapt in time, or become a cautionary tale of disrupted disruptors?

Investment strategies

Study supports what many suspected about passive investing

The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential.

Property

Should we dump stamp duties for land taxes?

Economists have long flagged the idea of swapping property taxes for land taxes for fairness and equity reasons. This looks at why what seems fairer may not deliver the outcomes that we expect.

Investing

Being human means being a bad investor

Many of the behaviours that have made humans such a successful species also make it difficult for us to be good, long-term investors. The key to better decision making is to understand what makes us human and adapt.

Sponsors

Alliances

© 2025 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.