Value stocks have lost their mojo. After an extended period from 2000 to 2007 where they outperformed growth stocks by a wide margin, they are now in one of their longest periods of underperformance ever. The below chart shows the iShares Core US Growth ETF against the iShares Core US Value ETF from 2007 to the present. As you can see, growth has outperformed value by almost 3 to 1.
The long stretch of underperformance has many wondering whether value investing even works anymore. A quick google search will return a litany of articles debating whether value investing is dead and whether the world has changed and growth will continue to dominate.
While the timing of any trend reversal in investing is impossible to predict, there are actually many reasons for value investors to be optimistic, despite all the negativity.
Here are four reasons I think value investors may be much happier about the next seven years than they were about the last seven.
Value Investing Works Over the Long-Term
It can be difficult to remember in times like these, but the long-term data that supports the outperformance of value stocks is compelling.
Fama and French’s paper from the early 90s confirmed the existence of the value premium and that value stocks outperformed the market over long periods of time.
A 2016 Bank of America Merrill Lynch study found that value stocks have outperformed growth stocks by over 4% annually since 1926 and have outperformed in three out of every five years. A 4% annual premium results in a total return for a value portfolio that is triple that of a growth portfolio over a retirement investor’s typical 30-year time frame.
In his 2017 research paper Replicating Anomalies, Lu Zhang tested 447 market anomalies and found that most anomalies do not hold up when microcap stocks are eliminated from the dataset (meaning the anomaly probably can’t be taken advantage of in the real world). But the anomalies that did hold up included pretty much all the standard value factors, including Price/Book, Price/Earnings, Price/Cash Flow and Enterprise Value multiples. This provides further evidence that the value premium exists, and that it works for multiple different variables.
The Trend is Your Friend – At Least in Reverse
Even though value works over the long-term, it can go through long and agonizing periods where it doesn’t work. From that perspective, what is going on now is not unique. In order to take advantage of the value premium, investors need to possess a significant if not extreme level of patience. To sit and watch your portfolio underperform for a period of years takes a unique individual who truly believes in the long-term nature of what they are doing.
Where the recent period of value underperformance is unique relative to history is in its length. The chart below looks at the 5-year return of value and growth back to 1945. When the line is above the dotted line, value stocks are outperforming and when it is below the line, growth stocks are outperforming. The fact that the line is in the white section the vast majority of the time is what you would expect given that value beats growth.
What is interesting to note, however, is what happens once growth outperforms for a five year period. In every instance historically, value was back to outperforming within five years, and that outperformance substantially exceeded the growth outperformance from the prior period. The one exception to that rule is the current period. The growth line crossed value in 2010 and there has been no substantial snapback yet. If history is any guide, that provides significant reason for optimism for value going forward.
The Valuation Gap is High
Another way to look at value vs. growth is the ratio in valuation between the most expensive stocks in the market (growth stocks) vs. the least expensive (value stocks). When that ratio gets higher, growth stocks are getting more expensive relative to value. When it gets smaller the opposite is true.
This chart looks at that ratio using the Price/Book. As you can see it has continued to widen throughout the past decade and the current value is in the 93rd percentile of all historical observations, meaning that value stocks have only been this cheap relative to growth 7% of the time.
Using the Price/Sales ratio instead of Price/Book confirms the same finding. Using this variable, value stocks have only been cheaper 5.5% of the time historically.
The Macro Picture for Value is Improving
Now that we have confirmed value stocks work over time, and are cheap relative to history now, the last question is what might be the catalyst that will get them going again? We may find the answer to that in interest rates.
Historically, value stocks have performed better during periods of rising interest rates. This chart looks at the performance of value stocks against the yield of the 10-year treasury. It shows that when the ten year is rising, value stocks tend to beat growth stocks.
This finding also is supported by finance theory. The value of a growth stock is based more on what it will do in the future (growth in earnings) whereas a value stock is valued based more on what it has in the present (current earnings and assets). When interest rates rise, the rate by which you discount the future earnings of a growth company to the present also must rise. So those earnings are worth less today, and so is the stock.
As the Fed let’s its bond portfolio mature (which it is already doing) and interest rates begin to move upward, this should benefit value stocks.
Being Right Often Requires Being Early
So the long-term case for value stocks is very strong. Research has shown that they outperform over time, and history also indicates they are due for a bounce back after a long period of underperformance. They are also currently cheap relative to growth stocks. And interest rates may provide the catalyst to change things.
But none of that means they are going to go up tomorrow, or even in the next year. As I talked about in my mean reversion article last week, trends in investing almost always take longer to reverse than you think they will. For patient investors who understand that, value stocks may currently offer a compelling opportunity.
The Case for Value Stocks
A cura di Jack Forehand, Validea Capital Management
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