Interestingly, the return of value has also coincided with the US equity market underperformance versus Japan, EM and Europe. The one common thread is that both value and non-US equities have been underdogs, significantly underperforming over the last ten years. This is understandable in a market that was shell-shocked by the global financial crisis.
Moreover, just when it had started to see light at the end of the tunnel, with some positive macro signs outside of the US, in early 2018 it got struck down again when President Trump started waging his trade war. What the recent outperformance of value and non-US equities shows us is that equity investors are increasingly uncomfortable overpaying for arguably crowded trades, whether from a style or regional perspective, and are ready for a change. They just need a trigger.
The resumption of the US-China trade negotiations and UK Parliament opposition to Prime Minister Johnson’s no-deal Brexit rhetoric provided such a trigger in early September. For this return of the underdog to continue, we need that light at the end of the tunnel not to disappear. Our base case scenario, of no hard Brexit and a slimmed-down version of a US-China trade deal, would keep the light visible, offering hope of bringing back some business confidence, capital expenditures and corporate earnings growth.
Clearly, in our alternative (and less likely) scenario of either no resolution or a meaningful setback in the US-China negotiations, an irreversible path to a US recession and corporate earnings across the world set to weaken, investors would return to seeking what is likely to become even more scarce growth among equities, the more visible the better, and willing to pay a premium for it. Value would go back into the memory drawer until the next bout of hope.
One pushback that we often get when talking about the future outperformance of value is the perceived correlation between yields and value. The mantra of value outperforming when yields rise and the yield curve steepens is common. So, how can value outperform in such a low-yield environment? Our quant team has looked at the correlation between value and yields from 1926 and has found that there is a positive correlation between value performance and the direction of yields over the last 10 years, but not over the preceding 83 years, as the figure below shows.
While we do believe that value is due a comeback, as fears in investors’ mind settle, we do not believe that all traditionally defined value stocks are bound for a sustainable outperformance. We believe that the traditional mono-dimensional definition of value based solely on a low P/B ratio, is outdated. In a world of technological breakthroughs, where economies around the globe are increasing their services and consumption content, retail and information flows have moved online, and production processes are more about software than hardware, we need to look at a far more multi-dimensional definition of value.
The outlook and sustainability of earnings over the longer term is just one of the key elements that should be part of the definition of value of the future. And while every initial value upswing is likely to start with a dash for trash, our search for value needs to be smarter, taking into account that in a changing world, companies that do not keep up with innovation may well stay behind and become value traps.