Value is experiencing the longest and deepest drawdown relative to growth since at least the 1960s. Fundamental forces and investor narratives that had been the trend for the last ten years have been super-charged even further through the Covid-19 crisis. In May this year, a tentative reversal in value’s long-term underperformance suggested that the picture was going to change. However, this proved short lived and unfortunately for value investors it feels like other factors need to align first before value truly emerges from the doldrums.
In May, the outperformance of value sectors such as financials, energy and industrials was due partly to investors reacting to the gradual re-opening of economies, increasing optimism for cyclical sectors, and secondly, for sector-specific reasons. For example, the energy sector reacted positively to a new agreement on oil production cuts among the OPEC+ nations.
Sector relative performance to MSCI World and US 10-year treasury yield
Source: Fidelity International Refinitiv Datastream. 05 June 2020.
This period of relative outperformance quickly faded as the strength of the cyclical recovery has come into question, and investors return to the safety of their steadily compounding names. This, however, brings us onto the key influences over a longer-term timeframe where we believe that risks may begin to favour value relative to growth.
Value underperformance in any given period can be explained by two main factors: value stocks delivering relatively slower earnings growth and relative valuations between the styles widening. It is certainly true that growth stocks have delivered superior earnings growth (as one might expect) but the impact of this on relative performance of value versus growth is secondary to the widening in valuation spreads between value and growth stocks (i.e. investors paying up for growth stocks). History suggests that this starting point bodes strongly for a reversal of recent performance trends.
For example, value stocks have never been on such low price-to-book, price-to-trailing earnings or price-to-forward earnings multiples compared to expensive stocks since at least 1968. This is a four to five standard deviation discrepancy, meaning value stocks have been more expensive than they currently are at least 99.9% of the time. On an industry-neutral basis (comparing valuations within industries, not the broader market) and excluding groups that could potentially skew the data, the results consistently show value stocks are at historically low multiples.
Table 1: Value stocks have not been this cheap since at least 1968
Source: AQR, May 2020.
Note: Value spread is the ratio of expensive stocks’ valuation to cheap stocks’. Data covers US stocks January 1968 to March 2020 Research.
Chart 2: Current value drawdown relative to growth stocks in the US exceeds any since 1963
Source: Research Affiliates, May 2020.
Note: Data uses the CRSP/Compustat US stock database from the period July 1963 to March 2020
In part this investor preference is understandable. Post-GFC economic growth and corporate earnings growth have been scarce and with interest rates low, investors naturally feel more comfortable owning stable companies in structurally growing markets. Whilst these companies may be expensive, they fulfill a requirement for steady compounding growth and a reliable income. Investors’ willingness to own typically more volatile value stocks reliant on economic growth or residing in structurally challenged industries has waned. The last 10 years have shown that fighting against this structural market preference has proven painful and highlighted that relative valuations can stretch further than investors might expect. However, previous cycles have shown that at some stage valuations do matter, particularly where there is some form of fundamental catalyst or shift in market optimism.
On a long-term view, when value stocks have approached this level of cheapness, they have delivered excess forward returns over expensive stocks, due to the market’s tendency for mean reversion. Given the level of outperformance in growth stocks over recent years and the concentration of market leadership among the tech mega-caps, value stocks could provide an additional source of return, particularly if the current market leaders enter a softer period.
Chart 3: Lower relative prices of value stocks correlates with higher future excess returns
Source: Refinitiv, June 2020.
Note: Shows MSCI USA Growth price-to-earnings premium over MSCI USA Value versus excess returns of MSCI USA Value over MSCI USA Growth. Monthly data December 1974 to May 2013.
We can suggest what the catalysts may be for the outperformance of value relative to growth, but timing with any degree of precision is obviously extremely difficult. What we would say with conviction is that we would expect to see out-sized performance from our value managers when the style tide does turn - but value managers must be positioned appropriately. Importantly, history has shown that rotations into value tend to be sudden and aggressive, and we witnessed this phenomenon in May. As such, attempting to time when to be exposed to value is unlikely to capture the tailwind effectively.
An important catalyst is likely to be the re-emergence of inflation from its deep dormancy, pushing up bond yields. This could be driven by the historically extreme and coordinated commitment by both monetary and fiscal policy makers to stabilise the world economy. It is highly likely that this commitment will continue even as recovery takes hold. Money supply growth is worth studying to monitor the picture. In the meantime, it is very difficult to argue with prominent investors such as Nick Train (who co-runs fund manager Lindsell Train) when he argues in favour of long-term growth stocks like Diageo on an earnings yield of 4% when gilts are yielding 0.30%.
A second less obvious catalyst could be earnings disappointment by growth stocks in an extended economic slump. For all their obvious and tangible problems, pockets of value stocks may already offer a good margin of safety for disappointing outcomes. If growth slows, growth stocks may find that they still substantially disappoint expectations which are obviously high, despite their more resilient long duration business models. There is little room for error.
Value manager behaviour
As the style underperformance has dragged on, our team continues to monitor the specific approaches and behaviours of value managers. In general, we believe that these can be divided into three distinct categories. First, some have become more value orientated in their approach - we have tagged them ‘deep value’ as they increased exposure to areas like financials and energy almost irrespective of shorter-term difficulties with earnings growth and balance sheet strength.
A second group have stuck to their ideology but have endeavoured to embrace the market shifts whilst staying true to value. This group will still provide heavily discounted portfolios and emphasise valuation, but their approach is more balanced giving equal consideration to the quality of the businesses, the strength of their balance sheets and the capital allocation or execution abilities of the management teams.
A third set have effectively thrown in the towel, predominantly for commercial reasons, and moved to more of a core benchmark approach. According to Morningstar data, the proportion of AUM invested in ‘blend’ or core funds has increased since 2009 whilst the proportion in ‘value’ funds has fallen by half to two-thirds depending on the region (as shown on the table below below). Our team remains most comfortable investing in the second group, i.e. those capable of capturing the upside should value return to favour whilst also providing an element of relative protection.
Source: Morningstar, December 2019.
Given the currently extreme valuation differential between expensive and cheap companies, we believe that value stocks may offer an attractive risk/reward profile if held over the long term. As we progress through the Covid-19 crisis and corporate earnings bottom out, value stocks could experience a strengthening tailwind as recovery takes hold. Valuations are particularly extreme in Asia ex-Japan than even during the run-up to the dot-com bubble, when growth stocks sold at 6x the price-to-book ratio of value stocks; today, that figure is 8x.