There is still value in value stocks

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The value rally has legs

Value stocks have been absolutely killing growth stocks. Here’s a one-year chart of the Russell Growth and Value indices:

Admittedly, it is hard to get rich outperforming by 20 per cent if the index you are outperforming is down by 25 per cent. That said, losing a little money is much better than losing a lot, and the performance gap is big enough to demand an explanation.

There are a handful of plausible, though incomplete, theories in circulation.

One is that as interest rates rise, growth stocks fare worse than value stocks. The idea is that more of the present value of a growth stock is contributed by cash flows far in the future; higher interest rates mean those far-out cash flows are discounted at a higher rate, and are therefore worth less. Absolutely true, when all else is equal, which it never is. Another, related idea is that a lot of technology stocks were in a bubble, and it simply popped. Finally, value indices got a lot of help from energy stocks this year.

Is anything else going on here? And more to the point, is value’s run likely to continue?

An interesting historical point — that I am never sure what to make of — is that for decades, periods in which value consistently outperforms growth, or vice versa, tend to be long. There have been three big regimes in the past 35 years, with growth outperforming from 1988 to 2000 and from 2007-20, with value outperforming sharply in-between.

Notice, first, that rates were falling for the entire duration of this chart, other than the bit at the extreme right, including 2000-07. This should rubbish the idea that value’s outperformance can be explained by rates alone. Second, it is interesting that the big regime shifts in 2000 and 2007 line up with market crises. Will the brief bear market of 2020 look, in retrospect, like another turning point?

Ben Inker, co-head of asset allocation at GMO, sees room for value to continue outperforming: “Value is still trading at a much wider than normal discount to growth [after] a great 12 months for value.” Here’s a GMO chart, using a composite measure blending price/sales, price/gross profit, and price/book ratios. It shows that by historical standards, value stocks are still cheap relative to growth. More precisely, the gap between the valuations of cheap and expensive stocks remains very wide:

There is a technical reason that the valuation gap has not closed more, Inker notes. “There is a bunch of stocks that were growth stocks a year ago that are not longer growth stocks — they hurt the growth universe along the way, and don’t make it cheaper now, because they are no longer in it.” For example, Meta was a growth stock a year ago; today it’s a value stock.

Crucially, Inker points out, it is the very cheapest of cheap stocks that explains why the gap is so wide. Here is a GMO chart of valuations of “deep value” (the cheapest 20 per cent of US stocks) versus shallow value (the next 30 per cent). On the Y axis, 1 represents long-term average valuations for the two groups:

The last time deep value was this cheap was at the turn of the millennium, right before value’s big run.

What are the cheapest of cheap US stocks? Unhedged had a quick look. Restricting ourselves to big caps, the stocks in the cheapest quintile of the S&P 500 in both price/earnings and price/book include a lot of banks (a perpetual favourite among value investors) but also commodity companies (Mosaic, Diamondback) homebuilders (Pulte, Lennar, DR Horton); communication networks (AT&T, Verizon, Dish); carmakers (GM, Ford); memory chipmakers (Micron, Western Digital); and some out-of-favour media names (Paramount, Fox). None of this is sexy software or rock-steady healthcare. None of it is buy-it-and-forget-it material. A lot of it is leveraged and/or cyclical. But a lot of these companies earn back their cost of capital and more — and the prices are right, relative to the rest of the index.

At any rate, value is clearly cheap. What is less clear is why value should be coming back into favour now. Inker speculates that “this is probably a good time for value now that there is a good deal of uncertainty over what the world is going to look like one, three, five years from now, and that makes people less interested in paying a big premium for companies based on what those companies are going to be like in one, three or five years . . . investors are less likely to fall in love with growth stocks when they are uncertain what the world will be like” in years to come.

We often talk to Rob Arnott, founder of Research Affiliates, about value stocks. He agrees with Inker that general macroeconomic uncertainty makes value appealing, and adds that the crucial source of uncertainty now is inflation. “Inflation is a friend to value investors,” he says. “There is no such thing as high and stable inflation.” Not only do the high rates that inflation bring in its train make long-term cash flows less valuable, but in uncertain times, certainty of cash flows becomes more valuable. Like Unhedged, he thinks inflation will grind down slowly — giving value stocks more time in the sun.

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