We all seek to spend our hard-earned pennies on things that we believe offer us good value for money. Whether researching the best washing machine through Which? or evaluating the impact of our charitable spending, we seek reassurance that what we spend our money on is giving us the best outcome.
So what is value in investment management? We recently asked our pension fund clients for a tweet-length definition of value for money and received an amazing response. Our judges liked the simplicity of "the amount you would be happy someone charging your mum", but the entry that I think encapsulates the challenge of finding value for money in investment management is "you know what you are paying and believe it is worth it".
This can also be applied to choosing individual investments. In fact, at the risk of being accused of overstatement, I believe that value is the most important metric in equity investment. Why? Well, as we look back over almost a century of UK market data, we seek to answer a crucial question in a world where everything – politics, economics, the companies that we can invest in – keeps changing: what can investors look to as a constant?
It turns out that constant is us – human beings. Markets are cheap when we are fearful, and they are expensive when we are greedy. Appraising value is the way we can adjust our investment decisions to recognise these behavioural biases. When you buy an equity, you are buying a share in a company. In this context, value could be measured as the price of the share relative to the company's earnings (referred to in City-speak as the P/E ratio).
History tells equity investors that, whatever people think will affect whether or not they make money, the one thing that actually makes a difference is the valuation paid. Every time the P/E ratio meant you paid between zero and £7 for every £1 of earnings, you would have made, on average and after inflation, 11 per cent a year for a decade. The small print is that every time the market was at those levels, something so scary was going on that you'd have had to force yourself to buy. But if you did, you were handsomely rewarded.
Whenever you paid a higher valuation, however, you'd see a correspondingly lower return, even if the price was entirely justified, such as by better business practice, higher growth or world-changing technology. It didn't matter if you turned out to be right. GlaxoSmithKline undoubtedly had high growth 10 years ago. Did you make money in Glaxo? No. The internet undeniably changed our lives. Did you make any money in internet stocks? No. The lesson is that knowing the future will not determine the returns you make. What will, however, is the valuation that you pay.