This year has not quite followed the script: investors were expecting improving economic growth and rising inflation to be accompanied by steeper yield curves, with the more defensive/quality stocks and so-called ‘bond proxies’ coming under pressure as bond yields rose. The strong rebound in value in H2 2016 was heralded as the style’s return to favour alongside a more pro-cyclical market regime. Instead, with the exception of the past two months, value stocks have lagged in 2017 as risk aversion set in once more.
So was last year’s value revival a brief outlier in the post-GFC underperformance versus quality and growth? Or is there still structural support for a long-term value comeback?
Over June and July, value in Europe recouped the total losses made in the first five months of the year. Can the momentum continue? Fundamentals are supportive – value remains cheap globally, and spreads remain very wide. The spread between the cheapest and the most expensive stocks are at levels last seen during the tech bubble and among the widest seen in the past 50 years. There is significant scope for this gap to narrow as the global economy continues to strengthen. Given the extreme valuation divergence, catalysts for value’s resurgence are not always necessary, and the scope for mean reversion could be enough on its own. However, a number of factors could also provide a positive tailwind over the medium term:
- Reflation: heightened inflation expectations have been under the spotlight recently and in particular inflation’s relationship with value. A positive relationship between the two holds over the long term. In times of deflation, prices of goods and services head downwards, and returns look better the further out you look. This is why growth businesses, and particularly stable quality companies with pricing power, have been prized of late and been great performers. The case for reflation remains intact, however, and a gentle pick-up bodes well for value investing. Generally speaking, out-of-favour stocks trading at a discount to the market tend to profit sooner (once intrinsic value is realised) as opposed to more expensive stable or growth businesses. Within an inflationary environment (whereby capital invested today will be worth less in the future), higher valued and longer duration (growth) stocks are therefore likely to take longer to provide a return. The opposite is true for value stocks which could see their underperformance reversed should inflation pick up.
- Bond yields: a key driver of value’s decade of relative underperformance has been falling bond yields, with a close correlation between the two. Changes in bond yields affect stocks differently given companies generate returns over different time lines. As with bond markets, longer-duration assets are more negatively impacted by rising rates. Investors therefore prefer current cash flows to distant ones when bond yields are higher, whilst they are more comfortable waiting for future profits when yields are low. As a result, higher bond yields pose a greater headwind to growth stocks than to value ones. With robust economic data across the world fuelling the global reflation trade and a continued move upward in bond yields (albeit at a slower pace) this should be supportive of value.
- Credit Spreads: credit spreads have been tightening since mid-April. The difference in how much corporates are compensating lenders over government bonds is shrinking and has been for some time. Tighter credit spreads are the result of global central banks maintaining low borrowing costs in the hope of encouraging economic growth. Whilst there is contention around the effectiveness of monetary policy efforts, the risk/reward in credit is broadly indicative of an impending cyclical rotation away from ‘safe’ assets. History suggests this supports value investing as investors look to take on more risk.
- Earnings: a key indicator of continued cyclical strength comes from corporates, which have delivered strong earnings performance so far this year. A positive story on earnings is critical to drive valuations higher. Relative EPS momentum has been improving for value stocks in absolute terms and against typically more defensive quality stocks. Currently, global sectors with above-average earnings and price momentum are all cyclical, including banks, industrials, tech and materials. In contrast, the more traditionally defensive sectors all have below-average earnings and price momentum, including consumer staples, utilities, and telecoms. History suggests stocks with relatively strong earnings and price momentum tend to outperform.
Further upside potential for value
Taken together, these factors should be supportive of a broad-based cyclical rotation and value’s outperformance. However, it is the ‘valuation of value’ which remains the cornerstone of the value argument. Given today’s exceptionally wide valuation spreads, it would not take much for some form of mean reversion to occur. Valuation alone could be the catalyst.
Notwithstanding any economic shocks, as markets start to function in a more ‘normal’ fashion – focusing on fundamentals such as valuations – it is likely that investors will continue to reassess the rich valuations of many quality stocks. As the valuation gap narrows, value should continue to outperform, albeit not necessarily in a straight line.
This article first appeared in Investment Adviser on 18 September 2017