There will always be something of a pricing gap between value and growth stocks – after all, it is the nature of the former to be cheaper while businesses that can demonstrate significant growth should always command a premium.
In the years since the 2008/09 global financial crisis, however, the gap between the two has become more of a chasm and today it is wider than it has ever been. The reasons are clear enough – from low interest rates and a lack of inflation to investors’ increasingly obsessive fascination with a handful of high-growth technology stocks – begging a crucial question for investors: when might this all change?
Certainly, the recent bear market in value stocks has persisted longer than most expected. “We are now 12 years into a growth market,” says Fund Calibre managing director Darius McDermott. “Investors might have assumed that loose monetary policy would eventually lead to inflation, which would be good for value. But inflation has not materialised and value has been left behind. This last year has only exaggerated the issue – if investors thought value was unloved in February, it was really unloved come April.”
The lag for value strategies has been significant. The S&P Value index had returned an average of 6.6% annually over the past five years, compared with 17.7% a year for the S&P Growth index. Indices such as the FTSE 100 that have an inherent value bias have seen similar long-term underperformance.
Growth stocks have been re-rated higher, while value stocks have been pushed lower. Apple’s price/earnings (P/E) ratio, for example, doubled from 19.5x in March to above 40x in September – in stark contrast to BP’s, which dropped from 28x to 13.5x over the same period. A straight P/E ratio is a crude measure and value managers will be looking at a far broader range of metrics but it illustrates the shift in sentiment nonetheless.
In value managers’ eyes, however, this presented an opportunity. According to Kevin Murphy (pictured), co-head of the value investment team at Schroders, by September, he and his colleagues were finding opportunities in every sector it analysed – and in ever corner of the globe, too. In addition to the UK, the top 20 holdings of the group’s Global Recovery Fund, for example, includes businesses headquartered in Australia, Canada, France, Italy, Japan, the Netherlands, Russia, South Korea and the US.
Shift in sentiment?
This long-term weakness corrected somewhat in November as positive news of a vaccine emerged and some stability returned to US politics with the election of Joe Biden as president. This is only a matter of weeks of solid performance, however – and value has a decade’s worth of underperformance to offset.
Nevertheless, investors are starting to ask whether this might be the moment sentiment at last shifts more permanently in favour of value. Murphy cautions that trying to call the turning point for value versus growth is a fool’s errand – as is looking to pick the moment when markets will wake up to the inherent value in any individual stock.
“All we can measure is what people have done and speculate as to why they have done it,” he says. “It is impossible to decipher motive. Certainly, we see that stocks can move on results announcements, new products or companies getting taken over. All we know for sure, however, is that if you buy the cheapest stocks, they do go up eventually.”
Even so, it is possible to draw some indications from history as to the type of conditions when value does well. “Value does well in a downturn where it is not associated with an economic downturn,” says Ian Lance, manager of the RWC Equity Income Fund. “It did well, for example, after the popping of the tech bubble in 2000 but badly in the wake of 2020’s economic decline. Value also tends to do well in a recovery such as 2009/11 – and possibly 2021.
“Value also does badly during periods when a narrative grips the market that causes investors to ignore fundamentals or valuations and we have seen this in periods such as 1997/2000, 2006/08 and 2017/20. On the other hand, value does well when this narrative goes too far and the dispersion in valuations between value and growth – which by then is very extended – begins to move back. This is another way of saying that value stocks have become too cheap and growth stocks too expensive.”
Relationship with rates
Equally, value has historically had a clear relationship with interest rates. Dan Brocklebank, UK director at Orbis Investments, explains that rapidly growing companies are equivalent to ‘long-duration’ assets because their cashflows are generated further out into the future. The discounting effect for cashflows is more powerful in year 10 than in year one or two, so, as interest rates drop, the value of long-duration assets goes up more than for shorter-duration assets.
With this in mind, Mark Preskett, a senior portfolio manager at Morningstar Investment Management Europe, believes we are entering a better environment for value investing.
“The reality is that today the divergence between value and growth is at extreme levels and should ultimately mean-revert,” he says. “We see a number of potential catalysts for this trend to reverse. History shows that rising bond yields and steepening yield curves have tended to coincide with cyclical stocks outperforming defensives.”
Part of this comes down inflation expectations – as distinct from actual inflation, which remains low. The roll-out of Covid-19 vaccines has increased expectations of economic growth, which in turn has led to market-watchers anticipating higher inflation. Inflation expectations had collapsed in March to their lowest level since 1999 – the point this measurement actually started – but have been ticking higher in recent months.
“Cyclical stocks are positively correlated with rising inflation expectations,” adds Preskett, “and the increase in break-even inflation indicates investors are worrying more about inflation than they were earlier in the year.
“In 2020, investors have rightly focused on the impact the Covid-19 virus has had on economic activity – and sectors such as banks and energy are deep in the red. Our view is that, as global growth expectations normalise, these two sectors in particular offer excellent long-term return potential. Investors are pricing energy stocks off bottom-of-the-cycle oil prices in perpetuity while, with financials, we have seen a return to profitability and balance sheets are in decent health. At some point, investors will look at again at both sectors.”
A new paradigm?
Still, there remains a nagging argument that the global economy has entered a new paradigm – in effect, leaps in technology are seeing unprecedented levels of disruption, which makes value a more difficult strategy to pursue.
Orbis’s Brocklebank is not convinced, however, reasoning: “Is it really more disruptive than the arrivals of air travel or electricity were? We are not seeing the huge rises in productivity that would imply significant leaps in overall economic performance.
“What matters is expectations. Companies become good investments if the future is better than expected. If expectations are met, there will be no change.”
As such, he believes all the elements are in place for the pendulum to swing back in favour of value.
There is another factor that may play a role in the revival of value – private equity and trade buyers. If public markets do not properly reflect the value of individual companies, there will be private equity groups willing to sweep in and buy up unloved companies.
By the same token, competitors and trade buyers may help realise the value inherent in unloved businesses and sectors. RWC’s Lance argues this is already happening. “We are seeing bids,” he says. “RSA was bid for, plus G4S and William Hill. Sometimes companies will break themselves up to realise value. Aviva, for example, sold its Singapore business. Alternatively, long-term buyers come in and take stakes.”
Value investors are the first to admit that, even with the recent recovery in value stocks, there is still a long way to go. As a strategy, value has underperformed for over a decade so the recent recovery has barely registered in the value versus growth debate.
Even so, there is one last consideration for investors and their advisers – diversification. After a decade of outperformance by growth stocks, many portfolios are heavily skewed towards the growth style. Any significant revival from value companies would leave many investors in little doubt they were not nearly as well diversified as they might have believed.
At this point in the market cycle, it would be a brave individual who did not ensure exposure to a diverse range of investment styles.
This article was first published in The Professionals’ Guide to Value Investing
