Multiple expansion may put value investing back in favor

The value style of investing in stocks whose share prices do not reflect the company’s potential has lagged the growth style for the past eleven years. The preference for ‘growth at all costs’ fueled another stellar year for global equities, but caused the value style to significantly underperform its growth counterparts yet again.

However, all of the 31.5% gain in the S&P 500 Index in 2019 is expected to have come from multiple expansion – where a stock’s the price/earnings (PE) ratio increases – which is due to sentiment rather than fundamentals. The last time such a multiple-fueled rally occurred in 1991 and 1998, it triggered periods in which value stocks outperformed for many years.

If history is anything to go by, the turning point may not be far away, says Mark Donovan, Portfolio Manager of the US Large Cap Equities fund, which follows the value style. It targets companies using Boston Partners’ ‘three circles’ of seeking stocks with attractive valuations, strong business fundamentals, and improving business momentum or catalysts for improvement.

He says the Russell Growth Index has had annualized returns more than double those of the Russell Value Index over the last three years, and that the average gap of 10.8% of outperformance is almost unprecedented.

“There has only been one other time when we have seen a more dramatic spread between the three-year return of growth and value stocks,” he says. “That, as you might have guessed, occurred in early 2000 at the peak of the dot.com bubble, when that spread was actually more like 20% – dramatically higher than even where we are today.”

Donovan notes that while it was more dramatic in 2000, “we had a similar 10% spread at the end of 1991. So, we have clearly reached some historic extremes in the performance differential between high and low valuation stocks.”

“What is noteworthy is the significant role that the expansion of price/earnings multiples has played in the recent market. Roughly half of the overall total return of the Russell 1000 Growth Index in the last three years has come from expanding multiples (see chart).”

“This multiple expansion for growth stocks was really most acute in 2019, and yet the earnings growth rate for the S&P 500 in 2019 is probably going to be roughly flat. So, that really means that effectively 100% of the overall market return in 2019 was a function of multiple expansion.”

Donovan says the last two times that multiple expansion accounted for all and in some cases over 100% of returns were in 1991 and 1998. Both periods were followed by the value style outperforming growth.

“Overlaying that fact with the dramatic outperformance of growth versus value peaking in 1991 and 1998, it's fair to come to the conclusion that history would suggest that when you go through periods of high absolute returns driven overwhelmingly by multiple expansion, you tend to be getting close to the transition points of value leadership taking over relative to growth,” he says.

“In the case of 1991, the value cycle began in 1992 when value outperformed by about 9%, but really took off in 1993, when value outperformed by about 15%. In the more recent period, the post-1998 period was more dramatic; with a bit of a tug of war between value and growth during 1999, but then dramatic outperformance for value that persisted over three years, in 2000, 2001 and 2002.”

Another historical signal for when value investing is coming back into vogue has been the inversion of the US yield curve, when longer-dated bonds yield less than shorter-dated ones. This potential trigger point was raised in an update in December 2019 by another Boston Partners Portfolio Manager, Josh Jones, co-manager of the Global Premium Equities fund.

The yield curve first inverted in May 2019, and the first signs of MSCI World Value Index stocks outperforming their MSCI World Growth Index counterparts were seen a few months later in mid-August 2019. However, growth soon reasserted itself, and value underperformed for most of the rest of the year.

So, is the evidence growing that an inflexion point is on its way? “The Fed cut interest rates three times in 2019, leading to a steepening of the yield curve, which has appeared to improve investor morale,” says John Forelli, Director of Portfolio Research at Boston Partners.

“Investors are now anticipating an improving economy. With this more confident outlook, we have seen what I'd call a subtle change in factor leadership recently.”

“Low volatility and price momentum have been leading the market, but now traditional value factors such as low PEs and free cash flow yields are beginning to make a comeback. We have not yet seen a turn in growth versus value indices, but perhaps we are seeing a precursor of things to come.”