Value Investing - Rising From the Dead
Buying “Value stocks” (i.e., public companies at reasonable prices relative to fundamentals) has been a hallmark of investing for over 100 years. Legendary investors like Warren Buffet parlayed the concept into billions of investment profits and many academics, like the famous Eugene Fama and Kenneth French, find it to be one of the primary factors explaining future stock outperformance. So, what has been happening to Value since the “Great Recession” – a period marked by the greatest underperformance of Value stocks versus Growth stocks in history? And, where do we go from here?
That last 10+ years have not been kind to Value. Over the last decade, the Russell 1000 Growth Index gained about 17% per year while the Russell 1000 Value Index gained about 10% per year. The outperformance has been so consistent and dramatic that some have claimed that “Value is dead.” It’s hard to argue with the results, especially when recent performance has been so lopsided. In 2020, The Vanguard Russell 1000 Growth ETF, VONG, was +38.3% while its Value counterpart, the Vanguard Russell 1000 Value ETF, VONV, was only +2.6%.
To understand this relative outperformance, let’s first look at some of the causes. We would argue that the primary driver of the general outperformance of Growth over Value has been government stimulus. Growth stocks are heavily impacted first and foremost by interest rates. Growth stocks expect cash flows to materialize further into the future than Value stocks so, when rates are low, there is less of a negative impact from discounting those cash flows to the present. As you may recall, the Federal Reserve Bank lowered the benchmark interest rate to near 0 coming out of the Great Recession and generally left it there for the better part of the last 13 years. They lifted rates a bit from 2015 to 2019 but the move was gradual and the benchmark rate barely rose during the period – peaking at just under 2.5%.
In addition to lowering rates, the Federal Reserve bank created the additional tailwind of increasing the money supply by buying bonds in the open market. These moves created an “easy money” policy where capital was generally free-flowing to large companies. Finally, in response to the COVID crisis, the Federal Reserve Bank began buying bonds of individual companies including behemoths like Apple. The net effect of this activity was to drop borrowing costs for large Growth companies to barely above US Treasury rates. In summary, cash has been easy and cheap for large public companies – a situation that helps all companies but is especially bullish for Growth stocks.
While rates remain low, it seems the market may now be predicting a possible regime change. So far in 2021, we’ve seen a noticeable rebound of Value stocks over Growth. For example, the deep Value energy sector ETF (XLE) is up 31.7% year-to-date through the end of April versus 7.7% for the high Growth tech sector ETF (XLK). A similar story is seen in Financials (XLF) which is up 23.5% and Industrials (XLI) which is up 15.5%. So, are we seeing a short-term blip in performance or a new secular trend?
Part of the recent outperformance of Value is simply optimism coming out of 2020. The same sectors that were beaten up in 2020 (e.g., Financials, Energy, etc.) are now some of the top performers. As the world continues to gain control of the COVID virus and economies re-open it stands to reason that the beaten-down sectors would see some immediate recovery. Financials are also benefiting from a steepening yield curve while the energy sector is seeing rapidly rising demand from renewed interest in business and leisure travel.
As we look forward, much of the market performance will depend on the actions of the Federal Reserve Bank. If rates stay low, Growth is likely to continue to be a top relative performer but, if not, one would expect earnings multiples to compress which would be a huge headwind for the sector. Overall, our bet is that we’re long overdue for some sustained Value outperformance. We see a number of tailwinds for Value relative to Growth including (1) the price to earnings spread between Value and Growth is extended relative to historical norms and (2) we’re seeing strong economic and employment Growth – meaning the risk of inflation has increased along with the prospect of future interest rate increases.
