almost 3 years ago • 5 mins
After nearly two decades of underperformance, cheap-looking value stocks have been showing signs of life this quarter. The million-dollar question is obviously whether the recent rally has legs – or whether it’s just another dead cat bounce. But if the former turns out to be true, then buying into value now may represent a once-in-a-generation investment opportunity.
Let’s look at three reasons why now might finally be value’s time to shine.
Value stocks are extremely cheap at present, particularly compared to fast-growing growth stocks. Research from investment manager AQR Capital Management earlier this month revealed that the main reason for value stocks’ long underperformance has been changes in valuations. It’s not that value stocks haven’t delivered – investors have simply been willing to pay a much higher premium for growth stocks.
That may sound over-simplistic, but it has important implications. First, the true “value premium” – the extra return you should expect from investing in value stocks over a broad index like the US S&P 500 – hasn’t disappeared, as some have recently suggested. Second, investors are in for additional returns if and when growth’s attraction dries up and the valuation gap reverts to its long-term average. So not only does value investing still work, but its extreme undervaluation makes it one of the most attractive opportunities out there right now.
A “reflationary” environment of high growth and relatively high inflation would likely benefit value stocks more than growth stocks for two reasons. First, value stocks tend to outperform during strong economic recoveries. That’s partly because previously cheap sectors are also often cyclical (like banks and energy), and partly because there are good reasons why value stocks are shunned during low-growth periods: they may be in declining industries, have high fixed costs, or are simply less “agile” than their fast-growing contemporaries.
When growth is scarce, investors are willing to pay a premium to invest in the adaptable Alphabets and Amazons of this world. But when overall economic growth rises, the tide lifts all boats and the relative attractiveness of growth stocks is reduced. Investors start to shift their attention to companies that have been underappreciated by the market – and which could deliver decent earnings if the economy keeps improving.
The other factor in favor of value stocks’ outperformance is rising inflation. If investors expect higher inflation in the future, they’ll require higher baseline compensation for the declining value of their money in the form of higher interest rates. Long-term rates will naturally increase more than short-term rates: what economists jazzily call a “steepening yield curve”.
And which sectors stand to benefit? Banks, for one: they typically borrow at short-term interest rates and lend at longer-term ones, profiting from the (growing) difference between the two. But for fast-growing companies expected to make most of their profits in the far-off future, long-term cash flows will now be discounted at a higher rate. The reality is a bit more complicated – but you can hopefully see why growth stocks have suffered from the recent rise in inflation expectations.
Momentum has been strongly behind growth stocks over the last decade, with everyone from hedge funds to retail investors fueling their rise. Momentum investors don’t care about valuations, they do care about performance – and value stocks have, as mentioned, been outperforming growth recently.
If value sectors like autos, banks, materials, and energy also become fully fledged momentum sectors, the added inflows from impetus-focused investors could push them higher still. With both value and momentum onside, this quarter’s rally could really turn into something sustainable.
I’ve purposefully avoided covering a couple of controversial points above, such as how exactly “value” should be defined and why value and growth aren’t always mutually exclusive. Those are interesting points, and I might share my views on them in a future Insight. For now, however, I think the following conclusions apply regardless of your precise position.
If you’ve got a long-term investment horizon of more than 10 years, value stocks’ extreme cheapness makes them an incredibly attractive investment. The longer your investment horizon, the more valuations matter, and the more you stand to profit from the gap between value and growth narrowing.
That’s the main reason why I’ve personally rotated most of my core stock market holdings into value (with a bias to smaller-cap and international stocks, but that’s another topic for another day). And even if you’re only looking to invest with a medium-term horizon of 1-10 years, I still think value could be a good play as the economy bounces back and momentum shifts away from growth.
Of course, investing is never a sure thing – and it’s important to know where the thesis could go wrong. In my view, the main risk is that the expected economic recovery disappoints. A lot of it has already been priced in by markets – and should, say, a resurgent coronavirus derail the global recovery, growth stocks could once again regain supremacy. Nevertheless, I think the potential gains – particularly over the long term – far outweigh the risks. It’s my strong belief that value stocks are one of the most attractive and asymmetric investment opportunities around right now.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.