Value is perhaps the oldest and most intuitive investment strategy. Most people are familiar with the concept of paying less for something than it is worth. As it relates to stocks, value investing entails purchasing a stock at a price lower than its intrinsic value based on a company’s cash flows growth and risk. Historically, this strategy has proven wildly successful, and investors have earned a value premium in excess of the market’s return for their efforts.
Lately, they have not.
Since around 2007, value investors have endured an unfortunate bout of underperformance with value stocks underperforming growth stocks by roughly 8% per year. The performance over this period stands in stark contrast to the 80 or so years prior in which value stocks often outperformed their growth counterparts.
In practice, value investors either estimate cash flows as far out in the future as possible and discount them back to arrive at a present value that serves as an estimate of intrinsic value or target investments in stocks that appear to trade at a discount to those with a similar growth/risk profile based on the ratio of their price and some accounting measure (e.g., price to sales, enterprise value to EBITDA). In either case, value investors attempt to use their judgement and expertise in an effort to purchase undervalued stocks and sell them when the mispricing is eliminated. Because (successful) value investing entails purchasing undervalued stocks, value is sometimes portrayed as a “safer” investment strategy with an anchor in today’s cash flows and asset values.
However, value companies tend to be less profitable than growth stocks and have a capital structure comprised of higher debt levels. As such, value stocks tend to have higher sensitivity to changes in economic conditions and thus tend to be more volatile. Most investors accept that risk & reward are strongly related yet some have regarded value investing as unlikely to compensate investors for the additional risk despite the fact that value stocks have historically provided adequate compensation to value investors.
POPLUAR EXPLANATIONS OF VALUE’S DEMISE
1. Value investing became too popular and is a victim of its own success.
This narrative suggests that shortly after the documentation of value’s historic outperformance of growth (around 1995), investors stampeded into value stocks, raising their prices, and dooming the strategy.
While it's true that popularity can kill a strategy, this explanation does not appear to be the case with respect to value investing and is not supported by financial data. More money has flowed into growth funds and the difference between cumulative value and growth flows stands near an all-time high. Also, growth outperformance has been driven primarily by changes in valuation rather than dividends or earnings growth, which suggests growth has been preferred by investors.
2. Low interest rates have driven greater demand for growth stocks than value stocks.
This explanation asserts that lower interest rates disproportionately benefit growth stocks since the bulk of their cash flows lie further out and they realize a greater boost to their valuations when these cash flows are discounted at a lower rate. This argument may have some merit and appears reasonable at first glance. Over the past 13 years, the recent period of growth outperformance, 10-year Treasury rates dropped from about five percent to roughly one percent. However, the correlation between 10-year Treasury yields and the difference in price-to-book ratios between growth and value has been a negative 0.14 since 1926, which is to say no relationship exists.
3. Value investing still works but value investors have adopted a flawed approach and value’s underperformance reflects this fact.
This argument proposes that selecting stocks based on valuation ratios (e.g., price-to-earnings) is not value investing at all. Proponents of this explanation suggest that value investing requires exhaustive research and/or a discounted cash flow (DCF) framework and that any quantitative approach is inferior. However, there is no evidence that suggests that value investors employing a more-in-depth DCF investment process have performed any better.
A SIMPLER EXPLANATION
So why has value had such a bad run lately? While the explanations above may have been contributing factors, the most likely answer is that value underperforms for some periods, sometimes long ones, but the underperformance is temporary. Value/growth relative performance cycles can endure for long periods (much like other investment cycles do). Many investors have not seen enough cycles to believe that value’s current slump will reverse at some point. While a value recovery may seem inevitable given its repeated occurrence throughout history, some investors feel like they are waiting for a day which may never come. Many investors, pros and day-traders alike, (understandably) have lost patience with and interest in value stocks.
A CASE FOR OPTIMISM AMONG VALUE INVESTORS
While there have been numerous ‘false starts’ of a value reemergence, and countless commentaries making the bull case for value over the past decade, we believe that the recent strength in value has staying power (at least in the short term) and we highlight the reasons for our confidence below.
1. Despite value’s strong relative performance since 4Q 2020, the valuation gap between growth and value stocks remains near historic highs. Growth is at least as expensive relative to value as it was during the dot-com era whether measured by price-to-book, price-to-earnings, or price-to-cash flow (see graph below).
Source: Kenneth French, Bloomberg
2. Value tends to outperform following a recession.
Coming out of a recession, value stocks tend to trade at very low valuation levels (even by value standards), and they are generally more sensitive to improving economic conditions. As a result, these stocks have a low bar to clear (given their low valuations) in an economic environment that makes clearing bars easier (given their sensitivity). The data supports this assertion since value stocks have materially outperformed in the two years following the last four recessions (see the graph to the left). Also, many value stocks will likely be more successful in beating dismal 2020 earnings levels than growth stocks, which should face greater investor/analyst scrutiny.
3. Buybacks are more likely to boost value stocks than growth. The practice of using surplus free cash flow to repurchase a company’s own shares, which is commonly referred to as a buyback, slowed dramatically in 2020 as companies sought to preserve cash. As pandemic risks fade and earnings improve, companies are very likely to begin announcing/resuming buyback programs to return cash to shareholders. Value stocks tend to benefit more from buybacks than growth stocks since buying shares at lower valuations has a greater proportional effect on the value of remaining shares.
4. Higher inflation and interest rates may provide a tailwind to value. Expectations of higher inflation and interest rates tend to benefit stocks generally and the impact is usually greater for value stocks. From an investor’s perspective, rising interest rates and inflation risk make fixed income investment relatively less attractive and stocks relatively more attractive. Over the last year, the relationship between the S&P 500 Index and 10-year inflation breakevens has been tight (see graph below) and accompanied by a recovery in inflation-sensitive sectors of the S&P 500.
Over the past decade plus, many investors have become fatigued with the underperformance of value stocks. So much so that it is easy to forget that value investing is a time-tested strategy that has yielded excess returns and been very successful historically. Growth stocks have had a great run as of late, but their valuations relative to value stocks are near all-time-highs and they face several headwinds that are tailwinds for value stocks. While we cannot guarantee investment outcomes, we can confidently say that it appears that value’s time to shine has arrived and value investors may yet be compensated for their patience.
DISCLOSURES
This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy, or investment product. Opinions expressed are based on economic or market conditions at the time this material was written. Actual economic or market events may turn out differently than as presented. Facts presented have been obtained from sources believed to be reliable. Nothing contained in this material should be taken as legal or accounting advice. Past performance is no guarantee of future results.