We think now is a very good time for investors to introduce value stocks to their portfolios. Investors adopting a more defensive investment strategy would be wise to gradually make space for value stocks in 2019.
Will 2019 mark the long-awaited revival of so-called value stocks? Value stocks are stocks of companies that are undervalued based on price-earnings ratios, mostly because of the boring, overly conservative business model these companies use. The lack of frills that characterizes these types of stocks is often why news about companies in this class elicits a tepid response from investors, in contrast to the way they devour news about growth stocks.
Value stocks have lost a staggering 35% against growth stocks in bull markets since 2009. Due to this long period of lagging returns, the relative performance of value versus growth stocks now seems completely out of balance. First, a similar performance in around 2000 heralded a rotation out of growth stocks into value stocks. This rotation also took place in a macroeconomic environment that, knowing what we know now, we can typify as ‘late cycle’ – a phase we also seem to have reached now.
Second, the price-earnings ratio of the MSCI Value Index is currently 21% below that of the MSCI World Index, which represents an above-average discount level. While value stocks should be cheap now, too, based on other valuation criteria such as dividend, price-cash flow ratio and book value, they look even more attractive compared to their historical average discount. With both valuation and the phase of the economic cycle in mind, a return of value stocks seems very likely.
Another aspect is that relatively efficient financial markets look further ahead than just one calendar year. As we look further on the horizon, the economic picture slowly changes. If the US economy continues to fire on all cylinders, the Fed will have no choice but to gradually, but resolutely, continue hiking rates to a level that will, on balance, put the brakes on the real economy. Historically, this transition to net tighter monetary policy has been a favorable environment for value stocks.
Rising rates will hurt the more rate-sensitive momentum and growth stocks and gradually more fine cracks will appear in this momentum-driven bull market, thereby increasing the downside risk. This environment will thus also set the stage for restoring more balance between the typical initial indifference of investors to value stocks and their corresponding disproportionate enthusiasm for growth and momentum stocks.
Nevertheless, there are also a number of risks that may hamper a value-stock comeback. As long as momentum stocks continue to forge ahead, there are few gains to be made for value investors. The leadership of momentum-driven growth and technology stocks in this bull market could persist given the negligible variation in sector rotation that has so far characterized the current market. Second, short-term investing has become so commonplace in this market that there doesn't seem to be any place for an investment style − like value investing − that requires patience. Almost no one talks about these dull business models.
Third, discount rates for the future cash flows (that result from the current low interest rates) of companies are still so low that, despite the rise in interest rates we envisage, they continue to boost the more interest-rate sensitive growth and momentum stocks.
Given the developments we expect to see in 2019, now is still a very good time for investors to introduce value stocks to their portfolios. While there is no urgency for this rotation, investors adopting a more defensive investment strategy would be wise to gradually make space for value stocks in 2019. From a risk-return perspective, the opportunity costs of holding value stocks have now become very low − too low, perhaps.
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