Schroders: Why Value Investing May Be Primed To Bounce Back

Schroders have just released a great report on the future of value investing saying value investing may now be primed for a comeback. Here’s an excerpt from that report:

It has been a miserable decade for the value style of investing, whose performance has languished behind its rival growth style. The recent low growth and low interest rate environment is largely to blame, as this has favoured growth stocks. However, the major headwinds are abating or even reversing and a significant valuation gap has now opened between value and growth stocks. Investors need to wake up to this underlying change in market conditions and start to re-evaluate value.

Numerous studies show that value stocks have outperformed growth stocks over the long-term. The difference in returns between value and growth is often referred to in financial literature as the “value premium”. However, since the Global Financial Crisis (GFC), value stocks, regardless of company size or geographic focus, have endured a period of significant underperformance. So does this “lost decade” mean there has been a permanent shift away from value?

We do not think so. For a start, value’s underperformance looks like an anomaly. On one measure developed by two leading academics, Eugene Fama and Kenneth French (see Figure 1), there have been only three significant bear markets for value in the last 90 years: the Great Depression of the 1930s, the Technology Bubble of the 1990s and the post-GFC period of the last 10 years. But the length and depth of the most recent episode is the most extreme on record.

The macroeconomic environment over this period has been marked by several unique features that have turned value on its head. But these conditions are abating or even reversing and a significant valuation gap has now opened between value and growth stocks. Against this backdrop, betting against value over the long term may no longer look like a winning trade. Our analysis focuses on the US equity market, given the greater availability of data. The themes we discuss are, however, broadly applicable to other regions.

Why value investing may be primed to bounce back

Despite this unfavourable backdrop, there are several reasons why investors should now be optimistic. Given what we know about why value has lagged, we can identify a number of factors that are likely to support it going forward. For a start, the aforementioned conditions have pushed the valuation gap between value and growth to its widest level in many years. Ultimately such divergence cannot last forever, as in the past, differences of this magnitude have correlated with significant value outperformance over the subsequent years (see correlations in Figure 7).

While some growth stocks continue to justify their valuations given their earnings growth and their prospects for further growth, it is highly unlikely that all growth stocks will realise the market expectations that are implied by current valuations. This is after all the law of large numbers: companies cannot sustain their growth pace forever. This is coupled with the risk of underperformance when such crowded trades unwind. A straw in the wind was the sell off in some of the tech stocks during the first quarter of 2018.

Clearly, it is not a one way bet that such companies will dominate forever. For instance, policymakers could tighten the screws on these industry leaders with new regulations or they may fail to maintain their technological dominance.

Figure 7 highlights six different valuation ratios as at 29 December 2017 and where value and growth indices lie along the percentile distribution of historical data. Green denotes cheap, amber is neutral and red is expensive. For example, using the price-to-book ratio, value currently trades at 0.4 times its growth peers.

This falls in the 37th percentile of the data distribution, which means value, on a relative basis, is cheaper than 63% of its history. That is a stark reversal from the peak of the previous economic cycle reached in 2007, when value’s relative price-to-book ratio was more expensive than 90% of its history.

While price-to-book is the measure of value with the longest standing, it also has its drawbacks. For example, many companies, especially those in the tech sector, require fewer physical assets today to operate compared to other companies in the past and this makes the book value of a business less meaningful. Nonetheless, investors should not ignore it completely, as historically the relative price-to-book ratio has been strongly negatively correlated with the value premium over the subsequent 10 years. Moreover, value is still cheap on a relative basis using other measures, such as forward-looking earnings multiples.

In summary, the valuation picture seems fairly supportive of value’s relative return prospects. One way that the currently wide valuation gap might narrow is through an acceleration in earnings growth.

This would discourage investors from paying a premium for growth stocks because they may find less expensive growth in value stocks. There is strong historical evidence for this relationship, as the annual value premium has been on average three times higher when the earnings growth of US equities accelerated than when it decelerated (Figure 8). Analysts are growing more confident about the likelihood of an earnings acceleration in stocks with valuelike attributes, as the forecast for their long-term earnings growth has more than doubled since reaching a 10-year low in 2016. It is currently the highest it has ever been in nearly 15 years.

Furthermore, many of the cyclical headwinds that suppressed the value premium have abated or even reversed. The US is no longer suffering from the hangover of the GFC and, although we expect interest rates to remain relatively well anchored at current levels, they are higher than they were a few years ago.

This fact, coupled with the possibility of further capital expenditure and spending on research and development, could translate into less spending on buybacks, which would help to narrow the gap in EPS growth between value and growth stocks. There is some evidence that this may already be underway, given that tech stocks have spent 21% less on buybacks in 2017 compared to 2015, while over the same period financial stocks have spent 30% more.

Figure 9 summarises how the five key drivers of the value premium may play out over the next 10 years. Overall, it seems the odds are stacked in value’s favour. To support this view, we have attempted to model the relationship between the value premium and its various drivers (see appendix for further details of our methodology). Based on current valuations alone, our model suggests value is poised to outperform growth over the next 10 years. In fact, we found that the 10-year Treasury yield would have to fall to zero over the next decade for growth returns to merely equal value returns, all else being equal. What could justify such a move? The US economy would have to experience either a Japan-style lost decade, another round of QE or possibly another financial crisis. But all of these seem unlikely in our view.