The outlook for value investors
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.
Seen from another perspective, extremely low interest rates in the US and elsewhere favoured equity strategies that focused on growth as opposed to value Jul ‘73 - Mar ‘78 Dec ‘80 - Aug ‘88 Nov ‘90 - Aug ‘95 Mar ‘00 - Feb ‘07 Dec ‘08 - Jun ‘14 Feb ’16 - Dec ‘16 12.7% 23.0% 29.4% 55.1% 35.4% 31.1% 19.9% stocks. Growth investing is an investment style concentrated on companies whose earnings are expected to grow at an aboveaverage 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.