Value investing over the past decade has endured one of its deepest droughts of underperformance relative to growth investing. This shortfall has spanned market capitalisation and geography. This begs the question: Is value investing dead or poised for a revival?
While there are no apparent signals to indicate when the relative performance trend may reverse, investors should be aware such reversals often happen very abruptly and tend to be extreme. It is difficult to accurately time a reversal, but relative valuation is often the catalyst. In some sectors, we are getting close to such extremes.
Moreover, to the extent there is higher inflation and a rising interest rate environment, some commodity and other cyclical companies could become relatively more attractive - for the first time in a long while. Over very long periods of time, value stocks historically have outperformed growth stocks. But the relative performance tends to be somewhat cyclical - raising the question of the timing of a reversal.
Valuation gap has reached extremes
It is impossible to predict when the trend may reverse. But over the most recent 10-year period, value underperformed growth by almost two standard deviations relative to its average 10-year performance, based on 10-year rolling periods starting in 1926. Following periods of such extreme dispersion between the two styles, history shows the odds of value outperforming growth over the subsequent three to five years are very high - more than above 70%.
Investors have pivoted to value when the valuation gap between the styles has reached extremes and when concern has risen the growth leaders could not sustain their momentum. Put simply, growth just becomes too expensive and fundamentals such as high profit margins show signs of peaking.
Interestingly, despite the superior performance of growth stocks over the past decade, the valuation dispersion is not abnormal. At the end of November 2018, the Russell 1000 Value Index 12-month forward P/E ratio was 0.74x the Russell 1000 Growth Index, slightly below the relative average P/E since 1978.
The growth style's dominance since the global financial crisis a decade ago has been particularly propelled by a narrow group of technology titans - the so-called FAANG stocks. For many big tech companies, profit margins and cash flows are at or near all-time highs, so relative valuations do not appear to be extreme - particularly after the recent downturn.
We are in uncharted territory in terms of how these huge tech and other high-growth companies will perform in a changing economic environment. In the value sector, by contrast, some of the companies have been operating for more than 100 years, so it is possible to understand how things have played out for these firms when the economy changed course.
We focus on investing in relatively high-quality companies trading below intrinsic value, believing valuation is the most important factor driving investor returns and outperformance in the long term rather than the level of earnings growth. Sustained, high earnings growth is rare. From 1985 to September 2018, only 45 of 10,845 companies in the Russell 3000 Index with unique 10-year periods of results posted more than 10% earnings growth per share for 10 consecutive years. So, valuation matters, because strong growth over long time periods is quite difficult to sustain.
Contrarian turnaround opportunities
As for the current investment environment, the overall large-cap US stock market is not cheap despite the recent pullback, but there are pockets of attractive opportunities. Some cyclical stocks with solid balance sheets suffered declines of 30% to 40% as investors began pricing in a recession. Our average holding period is three to four years, so we can be contrarian in looking for turnaround opportunities.
We are focused on finding companies with solid businesses, strong balance sheets and durable earnings profiles, those we believe can withstand a challenging economic environment. We balance the risk of our more cyclical holdings with steady, defensive companies such as utilities - which offer durable cash flows and higher dividend yields and dividend growth, with relatively modest downside risk.
In the housing sector, investors are concerned higher interest rates will affect affordability, leading to a slowdown. Some stocks are even starting to reflect recession-type levels of demand. Some auto stocks are also reflecting a poor macro environment, affecting companies we do not think are as cyclical as the market anticipates. A few stocks in the chemicals and paper and forest products industries and in the materials and consumer staples sectors are pricing in a growth slowdown.
Financials, our largest sector, had a big pullback, but we believe our holdings have strong balance sheets, maintain high levels of capital and have been conservative in lending practices. We expect the sector to continue to benefit from a gradual rise in rates and relaxation of regulation. Our focus in this sector is on attractively valued, idiosyncratic investments we expect to be solid performers in most economic scenarios.
In healthcare, some of the companies with appealing valuations have innovative growth platforms and do not have significant drug pricing risk. Medtronic, for example, is taking advantage of the increased needs of baby boomers for medical technology devices.
Generally, we remain optimistic about the US economy, especially as consumer sentiment remains strong, wages have increased, and corporate profits have surged due to federal tax reform. However, we mainly focus on valuations and fundamentals of individual companies, rather than trying to predict macroeconomic or geopolitical developments.
By Heather McPherson, portfolio manager of the T. Rowe Price US Large-Cap Value Equity Fund