Value investors are making one crucial mistake that is restricting their ability to outperform: failing to allow their stocks to run on once they have made a reasonable return.
This is the view of Alec Cutler, head of multi-asset at Orbis, who said: “Value investors will always buy something cheap that will go down another 30%. But then what they do is they wait to get a decent return on their invested capital, declare victory and then sell it off," without considering if it still has further upside.
Growth investors, by contrast, pick stocks that have the potential to make mega earnings in future years. This has been the winning strategy over the past decade and a half.
It is still working today. Over the past five years, investors would have been substantially better off buying a growth fund when it came to how they invested in global and US markets, according to recent Trustnet research.
This is partially due to the dominance of mega-cap growth stocks, such as the ‘Magnificent Seven’, which have performed very well.
Meanwhile, value has struggled to outperform, with the MSCI ACWI Value Index beating its growth counterpart in just four of the past 10 calendar years.
Cutler said some investors have “no idea what they are buying" in terms of the future potential of the businesses they invest in, simply instead focusing on the price. When shares rally, they sell out and allow growth investors to ride these stocks higher until they double or triple returns.
Because most value investors make this mistake, he argued that not many have managed to outperform. If value investors want to change this, he said they need to be willing to become a bit more momentum-driven when it is appropriate.
Rather than sticking rigidly to a valuation discipline, investors should “ensure they still have a valuation case and not blow a stock out of the portfolio just because it has returned to the market average”. Investors should reduce their allocations to these stocks gradually instead of selling out entirely so they can benefit if the stock continues to rise but also avoid any sudden losses.
“If you are willing to hold something for a bit longer, and if it has a lot of momentum on its way up from being super cheap, then you should continue to hold it and see if you can get more out of it”, Cutler said.
Defence stocks are a great example of how value investors can benefit from riding the wave of momentum, he said. The industry has performed very well for investors recently, with the FTSE All World Aerospace and Defence index up by 148.5% over the past five years. This is nearly double the performance of the FTSE All World as a whole.
Performance of indices over the past 5yrs
Source: FE Analytics
While they may be extremely popular now, defence stocks used to be an out-of-favour value play, Cutler said. In 2022, European Union regulations of ‘Social Taxonomy’, which would apply a border and internal tax on companies that “created social ills” drove the valuations of defence companies down. An investor could have purchased Rheinmetall on a share price multiple of around 4x, but it is "now a household name" set to join the Euro Stoxx 50 index.
“These stocks have doubled and then doubled again, returning to a market average multiple. At which point a strict value approach would say ‘That is it, we are out’, but it is worth paying attention to momentum and recognising that it would be nice to get paid more.”
Despite Rheinmetall's share price climbing by around 2,000% over the past five years, Cutler still believes it might have room to run. “No one wants to spend on defence, but when you have to spend on defence, you spend on it readily”, Cutler explained.
Share price performance of the stock over past 5yrs
Source: Google Finance
Already, Europe’s commitment to spend 3.5% of GDP on defence has boosted these stocks, while earlier this week UK prime minister Keir Starmer pledged to raise defence spending to 3% of total GDP by the next parliament.
Meanwhile, geopolitics remains a concern because “Russia is not going anywhere” and US president Donald Trump is pushing for countries to spend 5% of GDP on defence, providing significant tailwinds for further investment.
Investors need to recognise that a stock that has returned to the market average may still be undervalued, and by selling it too early, they can miss out. As a value investor, you should be willing to hold a bit longer if it means getting paid, he concluded.