Are value stocks making a comeback?
The capital markets are under pressure: geopolitical tensions, high inflation, rising interest rates and concerns about economic growth are weighing on sentiment and widespread uncertainty about the outlook for the future is causing significant price volatility. Value stocks are coping comparatively well in this environment. Stefan Brugger, portfolio manager of the global value equities strategy, explains the logic behind this phenomenon.
The investment environment has changed dramatically. “For many years, we had a Goldilocks scenario of low inflation, ultra-low interest rates and moderate growth. Now, the world has turned upside down,” says Stefan Brugger, Senior Portfolio Manager at Union Investment. “This means that investors need to adjust their approach.” The old equilibrium that existed before the pandemic, held in balance by the aforementioned factors and low geopolitical risk premiums, has now vanished. High inflation, fuelled by soaring energy costs, and uncertainty about the future trajectory of the war in Ukraine are posing huge challenges for fixed-income and equity investors alike.
The world’s leading central banks have responded to the rise in inflation by tightening monetary policy and the effects are plain for all to see: Mixed equity and bond portfolios have come under pressure as a result of rising interest rates. Moreover, concerns about a potential recession are mounting. In this environment, value stocks – i.e. favourably valued, fundamentally sound equities – have been performing significantly better in the market than growth stocks since the start of the year. Admittedly, both equity styles have suffered losses, but value stocks (measured by the MSCI World Value index) have weakened only half as much as growth stocks (measured by the MSCI World Growth index) and have also outperformed the MSCI World index.
“In the current market environment, value investing is a sound proposition,” says Brugger, a capital market expert and one of the portfolio managers in charge of Union Investment’s global value equites strategy.
Is value investing about to make a comeback? The question is whether the value style might generate a stronger structural performance over the coming years than it has done in recent decades. A number of factors suggest that this investment strategy, which was shaped by US investors Benjamin Graham and David Dodd, may be regaining some of its original appeal. Over the long term, value stocks have historically performed slightly better than growth stocks. And although growth stocks have delivered superior returns for many years, it is by no means a foregone conclusion that they will continue to do so.
Historically, major crises have often heralded a paradigm shift in the equity market. In the aftermath of the Asian financial crisis of 1977, for example, tech stocks fared significantly better than value stocks. After the dot-com bubble burst at the start of the new millennium, value stocks were highly sought-after, but later fell from favour again in the wake of the global financial crisis. Falling interest rates and yields in the bond markets paired with low inflation were the drivers behind the sustained rally of growth stocks from the financial crisis until 2021. And Brugger adds: “Companies were operating in an environment of persistently strong supply and meagre demand.” This meant that businesses invested less in areas such as capacity expansion. Then the coronavirus pandemic hit and companies scaled back their capacity even further. In fact, some went too far and were subsequently overwhelmed when demand surged as pandemic containment measures were lifted.
Value stocks currently have the upper hand
Value stocks remain attractive
Turnaround in interest-rate policy favours value stocks
As the coronavirus pandemic abated in most parts of the world, an all but forgotten phenomenon re-emerged from the shadows: inflation. In addition, globalisation – historically a key driver of deflation – has passed its peak. Supply chain disruptions and geopolitical risks are prompting many businesses to relocate production closer to home. This has intensified inflationary pressure and, in consequence, pushed up expectations of interest-rate hikes. Bad news for growth stocks: As their valuations are based to a large extent on future profit growth, they are highly susceptible to the impact of interest-rate changes on discount rates. If interest rates rise, future profits are worth less today and the prices of growth shares take a hit in the stock markets.
Equity investors should see this rotation as a warning shot. Growth stocks are currently weighted very heavily in major US indices on account of their exceptional performance record. But the pandemic has accelerated trends that may be more favourable for value stocks. If economic growth returns to a structurally higher nominal level – as Union Investment’s economists believe it will do over the longer term (not in the coming months) – more companies should be able to achieve adequate growth. The growth factor will thus become less of a rarity, which means that it will become harder to justify why growth stocks should trade at a premium.
In addition the term ‘growth stocks’ was historically almost synonymous with tech stocks. The pandemic has provided a tailwind for many structural growth topics such as e-commerce and card payment services as an alternative to cash. But from a long-term perspective, this is not a case of completely new potential for growth being unlocked but rather a case of existing potential being exploited more quickly. That leaves the question of whether these companies will actually continue to grow as robustly as forecasts have been predicting. The latest earnings figures published by companies such as Netflix and Amazon show that the potential for growth of FAANG stocks has largely been exhausted. For many growth companies, there comes a time when their business model shifts from a growth model to a value model. At this point, profitability becomes a more decisive value driver than revenue growth. As competitive pressure seems likely to mount, tech companies may have already passed the zenith of their profitability.
Consequently, value stocks are now coming into their own. The types of company that are most strongly represented in the value segment, e.g. businesses from the financial and energy sectors, tend to benefit from rising inflation and higher oil prices. At present, companies in the value segment are achieving stronger profit growth than those in the growth segment, where profits have recently taken a disappointing turn. Value companies tend to sell products and services that have already proved successful and popular with consumers and are generating adequate levels of profit and cash flow.
Focus on dividends and share repurchases
What does this mean for investors? Investors are compensated for the lower growth of value stocks by receiving a large proportion of the expected long-term return on equity (of these value stocks) of 6–8 per cent via dividends or share buybacks. In times of crisis, value stocks from various defensive sectors with lower profit volatility – such as pharmaceuticals, consumer staples and telecommunications – could potentially attract greater interest from investors. Nonetheless, the valuations of value stocks are currently still in line with the long-term average. Compared with growth stocks, which continue to trade at a premium, value stocks thus have a little more room for manoeuvre in terms of their valuation if interest rates continue to rise.
Investment strategy for global value equities
What criteria are applied in the selection of stocks for this strategy? Fund manager Stefan Brugger regards the following three criteria as essential in the bottom-up analysis:
Valuation based on long-term profit potential
A specific, clearly identifiable repricing trigger, i.e. a catalyst for a potential rise in valuation
Quality, in order to avoid ‘value traps’ (i.e. companies whose business model is at risk over the long term)
The core concept of the value approach is to identify companies whose profit level has temporarily dropped below its long-term potential and to sell stocks when profits rise above the company’s long-term potential. The portfolio managers analyse company-specific cycles that are driven by a market-based adjustment process. For example, cyclical companies are particularly susceptible to fluctuations in supply and demand, which the market regulates through pricing. If an industry is highly profitable, capacity in that industry will be scaled up. If profitability is low, capacity will be reduced and sometimes companies will become insolvent.
The fund managers prefer companies with a strong market position whose profitability is above average for their industry. Over the last two years, lockdowns forced consumers to spend a lot of time at home. This prompted a significant increase in demand for goods. For DIY retail chains and suppliers of computer hardware, printers and mobile phones, business was buoyant. They were able to generate profits above their long-term potential. But by now, most households are pretty well equipped with these goods and the focus of consumer spending is shifting back to areas such as out-of-home leisure activities. As a result, demand for services is rising again and companies whose revenue had dropped well below their potential while pandemic-related restrictions were in place are now seeing their profitability improve again.
Behavioural economics as a possible source of return
The fund managers are also using approaches from the field of behavioural economics, for example the contrarian strategy. A company that is currently going through a challenging period where its profits have come under pressure is more likely to be selected for this strategy than a company that is operating at peak performance and whose valuation reflects this. “The goal is to exploit market inefficiencies,” says fund manager Stefan Brugger. Often, investors will turn away from businesses that hit a rough patch because they perceive the deterioration as more severe than it really is. What they might fail to see is a turning point where things start to get better. In terms of timing, analysts’ consensus estimates often lag behind actual performance, which means that improvements sometimes go unnoticed in the market. Rigorous risk management and best execution of transactions are also important success factors. Close collaboration with a broad-based, experienced research team makes the job easier.
Conditions for value stocks have been challenging for many years and most fared poorly during the coronavirus pandemic. Against the backdrop of major shifts in the economic environment, driven by high inflation and the war in Ukraine, value stocks are now regaining popularity. In times of crisis, tried and tested business models that are less sensitive to cyclical ups and downs and can generate stable cash flows for investors tend to have an edge. In terms of returns, we expect value stocks to be able to make up some of the ground they lost to growth stocks in the past ten years. Our economists believe that inflation will remain stubbornly high for a little while yet before coming down again over the course of next year. However, they do not foresee it returning to the extremely low levels recorded before the pandemic but rather expect it to remain at a permanently elevated level. This will lead to higher nominal economic growth, which will further erode the growth premium that the markets had previously priced in, particularly for tech companies and online businesses. Growth is becoming less of a scarce commodity. As a result, value stocks should feature in a well-diversified equity portfolio.
As at 19 July 2022