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The past nine years have been tough for those managers employing the “value” style of investing. Investors following the value style will try to identify those companies where they think the market is too pessimistic about its future prospects – i.e. value investors buy stocks they believe the market has undervalued and whose future will be better than is currently priced in.
For more than five years – from the inception of the global financial crisis in early 2007, until halfway through 2014 – the value cycle underperformed the market by a cumulative 107%, one of the longest and deepest periods of underperformance of the value style. This is according to analysis carried out by Sanford C. Bernstein & Co. and Pzena Investment Management, a New-York based firm that has been managing assets since 1996.
Since early 2016 the value style began once more to outperform the market, producing returns in excess of the general market of about 20%. This was driven by companies shunned by the market up to that point, as investors were concerned about their ability to generate earnings growth.
These companies included those in the energy sector, which had experienced an extreme fall in the price of oil, and the materials sector, where mining companies and commodity producers suffered from falling commodity prices in a slowing global growth environment.
When global growth began to recover slightly, the oil price stabilised, China began to stimulate its economy by infrastructure development and commodity prices were driven upwards. The market began to improve its expectations for such companies, resulting in their share prices rising rapidly.
The start of a new value cycle?
After such a long and severe period of underperformance, investors are asking if this is the beginning of a period of outperformance for value, or if the cycle will be short-lived and the opportunity to invest in the value style already past.
The past 50 years show that pro-value cycles are typically longer in duration and greater in cumulative outperformance than the current cycle, which commenced early in 2016, as can be seen in Graph 1. Value cycles in the US have lasted 72 months on average and generated 162% excess returns cumulatively on average, versus the 11 months and 20% respectively of the current value cycle.
Analysis carried out by Pzena shows the potential difference in returns from the cheapest quintile of shares compared to the broader market (termed the “valuation spread”) remains wide throughout the world, especially in financials and generally cyclical businesses.
One way of showing this is by looking at the price divided by the earnings (P/E) of the shares in the S&P 500 US equity index. The P/E is simply the price market participants are willing to pay for the expected earnings one year out. If the P/E is low, it means the market will not pay a high price for the earnings – the shares are inexpensive and this is where a value investor might look for opportunities.
Analysis by ACPI Investment Mangers, which can be seen in Graph 2, shows how wide the dispersion is between the P/E ratios of the various quintiles of this market. This valuation spread means that there are many opportunities for positive surprises in the cheaper part of the market, which provides much potential for value as a style to outperform.
Growth investing
Seen from another perspective, extremely low interest rates in the US and elsewhere favoured equity strategies that focused on growth as opposed to value stocks. Growth investing is an investment style concentrated on companies whose earnings are expected to grow at an above-average rate relative to its industry or the overall market.
Market participants are prepared to pay high prices for such companies, because they think that the companies will, over a long period of time, grow at a faster rate than others. They are therefore prepared to sacrifice paying a relatively large amount of cash now, because they hope to benefit from the effects of compound growth in the future.
When interest rates are low, as they have been since the global financial crisis, investors are even more prepared to part with cash than at other times, since the benefit of holding cash or other “risk-free” assets, such as US government bonds, is less than normal.
This is why growth stocks vastly outperformed value stocks over the past years, which is relatively unusual. Graph 3 highlights this relationship since the 1930s and it shows that value typically outperforms growth by a wide margin.
Interest rates and value stocks
At the end of 2016, the US Federal Reserve raised interest rates and US 10-year government bond yields also rose. As we have noted above, when interest rates and bond yields increase, the market finds growth stocks less attractive relative to value stocks than before.
This is another reason why value as a style outperformed growth in 2016 and is inextricably linked to the expectation of stronger growth globally, but particularly in the US. This growth leads to inflation and prompted the US Federal Reserve to raise rates, even if the move was small.
Considering the length of the current value cycle relative to history, the signs of improved growth in many regions of the world, the wide valuation spreads and the trajectory of interest rates and bond yields, particularly in the US, there is certainly strong reason to believe the value cycle will continue to outperform, at least in the short to medium term.
Exercise caution
However, it is important to acknowledge this value cycle is in an environment where the interest rate and bond yield rise may be constrained.
Global growth and inflation have been severely constrained owing to a massive increase in government debt and corporate and household debt; demographic trends that have seen a decrease in the younger, consumer-orientated working-age world population and an increase in the older, savings-orientated population; globalisation; and diminishing productivity.
In addition, the economic cycle has been a long, shallow, extended one and we are more likely at the end of that cycle than its beginning.
Although this is balanced against the attempts of many governments to increase fiscal stimulus and the loose monetary policy of many central banks around the world, the current phase of economic expansion in the US is way past its sell-by date. It has outlasted all but three expansionary periods since 1854 and lasted nearly three times as long as the average expansion in the past. Graph 4 illustrates this.
The drivers of the value cycle – improving global growth and rising interest rates and yields – are vulnerable to a downturn. Any number of exogenous shocks could lead to this – from a spike in the oil price owing to war in the Middle East, to a decrease in global trade and growth as protectionist policies are enacted by the Trump administration and other governments. Should such an event occur during 2017, the factors that have led to an outperformance of the value cycle could rapidly reverse.
One should exercise caution in extrapolating the past performance of value cycles to the present one. However, it does look like this cycle is set to continue this year.
Adam Bulkin is head of global products at Investment Solutions.
This article originally appeared in the 2 March edition of finweek. Buy and download the magazine here.
