Morgan Stanley: It’s A Bad Time To Be A Contrarian

It’s a well-known fact that value investing tends to underperform in bull markets. As Seth Klarman wrote at the height of the dot-com bubble:

“ … I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone…can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes especially important…it helps you find your bearings when reassuring landmarks are no longer visible …” — Source 

Unfortunately, year to date, value strategies in European equity markets have underperformed strongly, and over the past twelve months growth strategies have been the outperformers.

Research from Morgan Stanley (NYSE:MS) released this week highlights the vast gap between the performance of value and growth strategies this year. Indeed, according to Morgan’s research, growth strategies in European markets have returned 18% on average during the past year. While a strategy investing in cheap stocks and shorting expensive stocks would have underperformed by 5% year to date.

Morgan Stanley

This data is based on European equities.

Morgan Stanley: Short ideas

Morgan Stanley’s research on contrarian performance is part of the company’s monthly European “Sellers Compendium”, which contains the results of a number of screens designed by Morgan Stanley’s research division to help find potential underperformers in European equity markets.

And over the past six years the compendium has yielded results. The median stock on the “Multiple Appearances” screen, (a collection of the stocks that appear on the highest number of sell screens) underperformed the MSCI Europe by 7.4% on a cumulative basis over the past six years.

Interestingly, at present the country with the highest number of stocks that qualify for Morgan’s “Multiple Appearances” sell screen is Sweden, indicating that the country has one of the most overvalued equity markets in Europe. On this basis, Austria, the UK and Germany all have the most undervalued markets.

Morgan Stanely: Most expensive screen

Morgan’s most comprehensive screen of European stocks is given the rather strenuous title of “Stocks with EPS downgrades where valuations are in the upper end of their 10Y valuation range“. The screen picked out 55 European stocks that are expensive compared to their own 10Y history across a range of metrics.

Stocks are evaluated based on their 10Y price to earnings, price to book and dividend yield figures. What’s more, the stocks that qualify have seen their earnings estimates downgraded consistently during the last three months. The list of stocks that passed the screen is shown below. Associated British Foods wins the award for the most expensive stock in Morgan’s European stock universe. (Morgan’s current price target for the company is 9.6% above the level the stock is currently trading at…)

Reversing Benjamin Graham

Every month Morgan Stanley publishes a list of the European stocks its analysts believe qualify for Benjamin Graham‘s “defensive investor” screen. You can find the list here.

In an attempt to weed out the market’s most expensive stocks, Morgan has constructed a “Reverse Intelligent Investor” screen. This screen uses the same criteria as the defensive investor screen, but in reverse. Specifically, stocks qualifying for the screen must have:

• A weak earnings track record — at least 1 of the last 10 years EPS <0
• EPS growth <33% last 10 years
• An expensive valuation with average P/E and P/B ratios being above the average market multiple.

Performance of this screen has been relatively impressive. Over 21 years of backtesting across the European equity universe, using a six-month holding period the screen produced an average relative performance of -3.3%.

Some of the companies that qualify for the “Reverse Intelligent Investor” screen at present:

Reverse Greenblatt

Along with the reverse Graham screen, Morgan’s analysts have also produced a reverse Greenblatt screen. (Like the Graham screen, Morgan Stanley publishes a list every month of stocks that qualify for the traditional Greenblatt screen.) The traditional Greenblatt screen looks for stocks on the premise of buying quality companies ‘on the cheap’. The screen ranks non-financial companies on two criteria, 1) ROCE (high is good) and 2) EV/EBITDA (low is good). On the other hand, the reverse Greenblatt screen searches for companies with a low ROCE and high EV/EBITDA (expensive and poor quality). A long-short strategy using both the traditional and reverse Greenblatt screens have produced steady returns over the past 23 years.

Some of the companies that qualify for the reverse Greenblatt screen at present:

Hype screens

Lastly, two “Hype Stocks” screens from Morgan Stanley. The first screen, named “Hype Stocks running out of steam?” looks for stocks that have high expectations and have rallied recently, but also have weak earnings revisions trends. All stocks meet four of the five hype criteria: in the top third