- Value stocks, capital spending by companies, and inflation are all rising together for the first time in years.
- High-priced growth stocks have outperformed less expensive value stocks over the last decade, but value has historically outperformed growth.
- The combination of higher inflation and capital spending could continue to benefit value stocks as the economy recovers.
- Value stocks may offer more opportunities for stronger returns than many investors realize and can help diversify portfolios.
From 2010 to 2020, expensive stocks delivered twice the return of cheaper—and possibly undervalued—stocks.1 But lower-priced stocks, also called value stocks, have historically outperformed more expensive growth stocks, and now value is emerging from the long shadow that growth has cast for the past 10 years. Sector strategist Denise Chisholm says there are reasons besides history to suggest the value revival may be more than just a passing phase.
Cumulative returns of the most and least expensive quintiles of the total US stock market by price-to-book ratio
Chisholm says she sees value stocks benefiting from the same forces of pent-up consumer demand and free spending that have awakened another sleeping economic giant, inflation. While government stimulus and welfare spending is helping drive consumer demand for goods and services, capital spending by companies is rising to meet that increasing demand. To meet demand and comply with new regulations, well-established companies, mostly in manufacturing, are spending money to reconfigure their existing plants, equipment, and processes. The stocks of these types of companies are usually classified in the "value" category, and history shows they have tended to do well when inflation ticks higher.
Chisholm points out that value's modest performance in recent years has been accompanied by low inflation and low capital investment by companies. "We've not seen a true US capital spending cycle in more than 20 years. During that time, companies focused on outsourcing and using technology to increase productivity at plants that couldn't be outsourced, rather than spending on domestic production capacity. During that capital spending drought, value stocks of companies whose earnings are driven partly by capital spending got cheaper. Now capital spending is coming back and value stocks are recovering," she says.
A long-term trend?
Increased capital spending is helping lift value stocks, but is this the start of a return of value to its historical role as market leader? Chisholm says that measuring how much manufacturing capacity is currently being used may help investors understand how long a rally in value stocks could run: "If capacity utilization is low enough—and it's very low right now—it could increase for a long time." With this in mind, Chisholm says she believes value stocks could potentially present attractive opportunities through the current economic expansion. "This is such a unique recovery. It's nothing like the one that followed the global financial crisis. It took from 2009 to 2015 to recover only 75% of the almost 20% of our manufacturing production that was lost in the recession. We've gotten back 100% of what we lost to the COVID shutdowns in under a year."
There are risks, of course. The current economic expansion is vulnerable to "an extreme increase in real interest rates or in oil prices that could bring about a recession," says Chisholm. As unlikely as it may seem given recent history, value stocks could also potentially become victims of their own popularity if investors start bidding up prices. "If value stocks get overvalued relative to stocks that grow, that could end the rally," she adds.
Value stocks have been overshadowed by growth stocks long enough that some investors may need a reminder that they can provide potentially better-than-expected performance as well as diversification, particularly in an inflationary environment. It's also easy to assume that growth stocks are the fastest-growing stocks and that investing in other categories of stocks means forsaking growth. But history shows that both cheap and expensive stocks have been roughly equally represented among the fastest growers.
From December 1994 to December 2019, only 22% of the fastest growing stocks in the Russell 1000 came from the most expensive group. And while cheap stocks as a group have historically grown earnings more slowly than the market average, 23% of the fastest growers came from the Russell's cheapest segment2.
Most investors also likely know that Amazon has ranked among the top-performing stocks for quite some time with about 24 percentage points of historical positive relative performance per year. Few may know, though, that cheaper stock of Target had delivered similar results, over the same time, or that Dollar General had beaten both Amazon and Target with 29 points of outperformance as of May 31, 2020.
Joel Tillinghast, manager of Fidelity® Low-Priced Stock Fund, says Amazon is also an example of how important research is for value investors. "The challenge of finding undervalued stocks is that accountants don't know how to value intangibles such as brands, intellectual property, and good will with customers," he says. Tillinghast says he, like many others, didn't spot the opportunity to invest in Amazon before it emerged as a retail juggernaut and exemplary growth stock. "For many years, Amazon reported either losses or not very big profits. At the same time, it was building up an increasing number of loyal customers who kept purchasing more and more stuff from it. Those customer relationships turned out to be very valuable, even though they weren't visible on the company's income statement."
Tillinghast says experienced professional investment managers can look for growing sales to identify companies with value that the market doesn't perceive. "We look for growing free cash flow, which is cash from sales that's greater than the amount of capital that they're spending on operations," he says. "Amazon's free cash flows were better than you would have expected given their not-very-good profitability 10 years ago. That was a hint that their businesses were not very capital intensive. They were growing sales fast and they were producing cash that they could return to shareholders or invest in new businesses. Now their profits are great."
After 10 years of high-flying growth stocks, many investors may face unexpected risk from having more exposure to growth than they want, even if they've invested in blended mutual funds that seek to provide diversification as well as growth. Value stocks now make up just 18% of the total value of US stocks, which means the large-blend or large-cap core mutual funds that are basic building blocks of many portfolios may be much more heavily weighted toward growth than they once were. Investors interested in adding value stocks to help diversify away some of these risks can find opportunities by running screens using the Mutual Fund and ETF Evaluators on Fidelity.com. Here are the results of some illustrative mutual fund screens (which are not recommendations of Fidelity).
- Fidelity® Low-Priced Stock Fund (FLPSX)
- Fidelity® Value Fund (FDVLX)
- Fidelity® Value Strategy Fund (FSLSX)
- Fidelity® Value Discovery Fund (FVDFX)
- MFS Mid Cap Value Fund Class A (MVCAX)
- American Century Mid Cap Value Fund Investor Class (ACMVX)
- BlackRock Mid Cap Dividend Fund Investor A Shares (MDRFX)
- Heartland Mid Cap Value Fund Investor Class (HRMDX)
- Fidelity Value Factor ETF (FVAL)
- Vanguard Value Index Fund ETF (VTV)
- iShares Trust Russell ETF (IWD)
- iShares S&P 500 Value ETF (IVE)
Separately managed accounts
- Fidelity Equity Income SMA
The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.