Until last summer, value investing had been lost in the wilderness, languishing after a decade of underperformance relative to its rival growth investing. The first signs of a renaissance broke through about six months ago, with a decisive rotation in equities – stocks that were cheap compared to their fundamentals were suddenly fashionable again. What quickly followed was an epic reversal from ‘worst to first’ as value rapidly gained steam. In fact, value didn’t just outperform growth in the most recent period; it dominated across virtually every major region (from emerging markets to US) and across market caps (from mega to small caps).
Investors are now left asking whether the breakout performance for value constitutes a lasting regime change or just an isolated round of good fortune. In our view, the value style is well and truly up off the mat and poised to fight back.
Scrutinised since the 1930s by the iconic work of Ben Graham and later popularised by Warren Buffett, value investing has long been accessible to investors. Academics have been documenting the value premium since the 1970s. In our view, investors tend to be overly pessimistic about value companies, unfairly extrapolating earnings trends into the future, which in turn drives a wedge between price and fair value, creating buying opportunities. Successful value investing relies on sticking rigidly to the style in order to benefit from the strategy’s long term performance potential, especially when it feels emotionally most uncomfortable.
Since the beginning of 1975, the average duration of those periods where value outperformed growth, using the MSCI Europe style indices as proxies, is approximately 28 months with value’s longest period of outperformance lasting 80 months. The current rally has lasted 6 months so far, which would suggest this recent value revival may be just the beginning of a more sustained rally, especially when put in the context of the preceding 10 year value bear market.
Because value has so significantly underperformed, today value stocks are still trading at a meaningful discount to growth stocks – to a degree not seen since the depths of the eurozone crisis – even in spite of the recent rebound, as shown in the chart below.
Indeed, one of the best predictors of future returns to the value style is the valuation spread (meaning the difference in valuation between the cheapest and most expensive stocks in the market). Due to this decade’s extremes, the difference in valuations between the two styles is currently still in the widest quintile compared to history. That suggests a positive outlook for the performance of the value style in the next year.
Furthermore, whereas value sectors of the market are pricing in the assumption of negative implied long-term earnings growth, we think expectations could be too pessimistic. For example, we would argue that the market’s earnings growth expectations for autos (implied -4% earnings decline per year for the next 10 years), insurance (-2% earnings decline per year for the next 10 years) and banks (-1% earnings decline per year for the next 10 years) are all overly bearish.
It’s worth also considering whether changing macro-economic dynamics are poised to bolster value style investing. Over the last five years, as both interest rates and inflation have fallen, it has been the high duration bond proxy assets that have outperformed. This sustained outperformance means that they are now trading near historical extremes. Now we’re at the end of a thirty year bull market in bonds as inflation expectations begin to rise and interest rates increase from near zero levels.
Historically the value style has outperformed in periods of rising inflation and we believe that this relationship remains valid today. At a style level value stocks are lower duration assets, compared to growth stocks which have a valuation which is more sensitive to cash flows further in the future. As the yield curve steepens the cash flows of growth stocks will be more heavily discounted and therefore value stocks should be expected to outperform.
If you believe that there is a degree of cyclicality to the value and growth investing styles, as we do, there is good reason to believe that value is finally punching back – and maybe just getting started.
Ian Butler is a fund manager at J.P. Morgan Asset Management