Value investing is all about patience, but the current market cycle is testing the resolve of even the most dedicated disciples of Graham and Dodd. Although value managers haven’t lost money, they have watched growth managers steadily pedal away: Over the past decade, large-cap growth funds tracked by Morningstar have returned 15.6% a year on average, versus 13.2% for large-cap value funds.
Historically, value-style investing has performed in fits and starts—typically lagging behind growth for extended periods but ultimately winning the race, at least for investors who don’t drop out before the finish line. From January 1927 to December 2018, U.S. value stocks have posted an annualized return of 12.6%, versus 9.9% for U.S. growth, according to research from Gernstein Fisher.
Over the course of this market cycle, however, the gap between value stocks and growth stocks has gotten so large, and been so persistent, that some wonder if value will ever catch up. The valuation spread between the cheapest and most expensive stocks in the Russell 1000 index (.RUI) recently hit its widest point in nearly 20 years, says Nomura Instinet. By some measures, it’s the widest in history.
That has led investors to ask whether value stocks are the greatest deal of the decade or on a steady slide to obsolescence. It turns out that the answer—much like the distinction between value and growth investing itself—is more nuanced.
“People say, ‘Isn’t being a value investor the best way to make money?’ ” says Joseph Mezrich, quantitative strategist at Nomura Instinet. “We make the point that context matters.” In a March report, he and his colleagues argued that the yield curve might be the single biggest indicator of the outlook for value stocks.
Before 2010, there were periods when relative valuations between cheap and expensive stocks ballooned, says Mezrich, but it always pulled back. That really hasn’t happened in this cycle. If anything, growth has continued to get an edge.
“What changed in 2010 was quantitative easing and its impact on the yield curve,” he says, explaining that when the yield curve flattens, it gives cash-rich growth companies an even bigger advantage over value stocks, which tend to carry more debt. An inverted yield curve—like we saw in late March—only amplifies that dynamic. “Value will come back, but not until we see a persistent steepening of the yield curve,” he says.
Value investing isn’t as simple as finding great companies trading at attractive prices. There are many theories for why value has underperformed. The easiest one to grasp: Legitimate bargains abound early in a market cycle, but eventually value stocks get picked over. If something is cheap in the later stages of a bull market, it’s usually for good reason. “Value tends to be a very, very good early-cycle trade, and a very bad mid- to late-cycle trade,” says Nicholas Colas, co-founder of DataTrek Research. “That’s exactly what we’ve seen. It’s just that this cycle has gone on forever.” Value-style investing tends to cluster in a couple of industries, he says, namely financials and energy, which together account for a third of the assets in the Russell 1000 Value index (.RLV), versus just 5% for the Russell 1000 Growth index. Tech accounts for less than 10% of the value index and a third of the growth index.
The implications have been particularly pronounced in this market cycle—and not just because tech has trounced financials, says Harry Hartford, co-manager of the $7.4 billion Causeway International Value fund, who also blames unconventional monetary policy. “In some places, long-duration bond yields are negative or zero,” he says. “When interest rates are that low, growth is more valuable.”
This pattern has played out before, but it has been particularly notable in the past decade, which has been the “longest, biggest, broadest period of monetary policy,” says Brian Singer, manager of the $933 million William Blair Macro Allocation fund. Consider the impact on financial stocks: “When central banks are manipulating asset prices and interest rates, it squeezes the balance sheets of financials, and suddenly the true underlying fundamentals of the business are masked by interest rates that are not market rates,” he says.
When central banks back off, says Singer, this dynamic should flip. Then again, investors have been waiting for years for this to play out.
“The hard question to answer is whether this is one of those periods where value is just out of favor, or is this a regime change?” says Ben Carlson, director of institutional asset management at Ritholtz Wealth Management. One popular explanation for value’s chronic underperformance is that as tech shakes up virtually every industry, it drives an even greater wedge between innovative growth companies and old-school value ones.
Intangible assets, such as software or a brand, are a bigger factor in new-world companies, but price-to-book ratios—a popular measure of value—don’t accurately reflect them. This can make growth companies appear more expensive, and could contribute to the growing disparity between growth and value—and mislead investors who are banking on a reversion to the mean.
“We don’t like to think ‘this time is different,’ ” writes Gregg Fisher, head of research at Gerstein Fisher, which manages multifactor strategies. “At some point, the cycle will likely turn and value will regain the upper hand. But it’s hard to say when.”
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