Value investing will come back into fashion, despite the long rally in growth investing, say market specialists Mike Mullaney and Dan Farren.
The value investment style has consistently underperformed over the last decade, prompting many to question whether the cyclical nature of investing will bring its eventual return, or whether the internet age means ‘this time it’s different’.
However, an inflexion point is likely to come sooner or later, triggered by a number of formerly unfashionable sectors and some macroeconomic factors that favor value stocks, says Farren, senior portfolio analyst with Boston Partners. He says this time it’s no different, and the ‘bargain hunting’ principles of value investing are still valid.
Value investing is the practice of looking for companies whose share price does not reflect their underlying business fundamentals or prospects, allowing for considerable upside in the stock. Boston Partners has been a value investor since the 1980s, following the ‘three circles’ concept’. This looks for companies that are relatively cheap; have strong fundamentals; and have an underlying business momentum, where there are catalysts for positive change that are not reflected in the share price.
The biggest problem for value investors is that growth stocks have significantly outperformed their value stock counterparts since 2007. This process has been exacerbated by the rising dominance of the FAANG stocks – Facebook, Amazon, Apple, Netflix and Google – which make up 21% of the Russell 1000 Index.
As the internet era has created these new mega-companies, their inexorable growth has brought handsome returns for their shareholders, says Mullaney, director of global markets research for Boston Partners. The combined market values of FAANG is now USD 3.4 trillion, or higher than the GDP of most countries. In 2018 alone, Netflix has doubled in value, while Apple became the world’s first trillion-dollar public company.
Trying to beat indexes that are loaded with growth stocks has therefore proved troublesome, particularly since the market correction of early 2018, which caused a stampede into ‘expensive defensives’. These stocks also pose problems for value investors, as they trade on high earnings per share multiples, but with little likely upside for the stock. As such, they don’t meet the three circles criteria and cannot be bought, meaning a fund will likely lag an index in which they feature prominently.
As always, it’s important to be a long-term investor, with an eye on the main prize. “Value has outperformed growth pretty meaningfully since 1979, but growth has now outperformed value since 2007, the longest stretch ever,” says Farren. “So, people are asking if value investing as a concept is broken. Is it different this time, and does gravity no longer apply? We don’t think that this is the case.”
“The idea of buying assets that are undervalued where there is a reasonable catalyst for change is always going to make sense. If you have a long-enough time horizon, most money in the world has always been made by people who were liquid when everyone else was panicking, and we think that that is still incredibly pertinent.”
“Value is timeless. From 1920 to 2006, buying value stocks yielded a 5% annual premium, but this has inverted since 2007 becoming a negative 1% return, a reversal of 6%. The mentality changes, but the cyclicality is always there: from 1969 to 1977, value outperformed by 145%, and from 1999 to 2005 the outperformance was 90%. So, there is great potential for value, when the market eventually turns.”
Farren says value investors can look forward to several upcoming tailwinds, one of which is the likely future performance of formerly out-of-favor sectors such as Energy and Financials, which have recently benefited from higher oil prices and interest rates, respectively.
“Even if you do still like the growth stocks, you must expect a reversion at some point... so what would start it?” Farren says “Energy is currently only 0.7% of the Russell 1000 Growth Index and 11.4% of the Value Index, but as a result of the rise in oil prices, the sector was the biggest gainer in the second quarter.”
“If Financials also do better, then this could be the inflexion point that we’ve been looking for, since all the factors that benefit Financials such as rising interest rates are now in place. If the Technology sector slightly underperforms the market, you’ll see some meaningful outperformance by value stocks.”
Meanwhile, research shows that macro factors for value investors are positive when corporate earnings are strong, GDP growth is above 2%, and interest rates are rising. Boston Partners focuses entirely on bottom-up stock picking, but sometimes understanding the top-down view can also offer insight.
“We do know from past experience when these three factors are present, value eventually outperforms growth,” says Farren. “We hit the perfect storm after the financial crisis, but it will turn around. These things are always cyclical, and this time it is no different.”
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