Value Investing

Why Now May Be The Moment To Get In On Value Equities

Why Now May Be The Moment To Get In On Value Equities by BlackRock

Value equities have been among the most susceptible to recent bouts of volatility, causing many to turn away from this flavor of stock. Bart Geer discusses why that may be precisely the wrong move.

The market’s almost immediate plunge to start 2016 cast a pall over what might have been shiny prospects for a new year, just two weeks from the Fed’s “balanced” assessment of U.S. economic conditions and the first rate hike in nearly nine years.

Often forgotten in the doom and gloom is that volatility means down … and up.

What intrigues me as a 30+ year value investor is that value stocks have been among the most volatile. And that seemingly has sent investors packing. At the end of 2015, there was $2.7 trillion in growth mutual funds, almost double the $1.5 trillion invested in value mutual funds.

This underallocation to value stocks could mean missed opportunity. Let’s look at a hypothetical $10,000 investment in growth, core and value segments over the last decade. We can see where an investor might have missed out in this case.

Value equities

Value equities – Opportunity in the making

We believe the recent overallocation to and performance strength in momentum and growth sets the stage for investor rebalancing. While the long-term path to value outperformance is not a straight line, and may be marked by alternating spates of value and growth leadership, we fully expect that investors are going to want and need to re-allocate back to value in their portfolios.

As shown below, some of the periods of greatest value underperformance are followed by some of the most significant periods of outperformance. While the timing is impossible to predict, it’s not too great a leap to suggest we may be setting up for a rotation in favor of value stocks.

Value equities

Actively seeking value

Beginning in August of last year, the market began to price in weakening global economic conditions. The bearishness tightened its grip in the fourth quarter and early 2016 and, as a result, we saw defensive stocks bid up to very full prices as value stocks got cheaper.

It seems clear to me that the heightened volatility over this period has created attractive valuations in certain areas of the market. Indeed, by producing dislocations in the market, volatility effectively separates the potential stock winners of the future from underperformers.

As the chart below shows, the valuation spreads within sectors are wider than their long-term historic average in many areas of the market. The greater the controversy in the investment case, the greater the dispersion in valuation. That means some stocks are priced low and others high. We are seeing that most acutely in the energy sector.

Value equities
Value Equities

But buyer beware: Determining which of those low-priced names are true bargains and which are priced low for good reason requires deep understanding of each industry and company.

While we approach the market stock by stock, certain areas seem riper for the picking now:

Banks. We see banks as less volatile than they have been in the not-too-distant past, characterized by stronger balance sheets and less volatile results. Yet, they are trading at lower valuations.

Energy. The key questions here are: 1) when will oil prices bottom and 2) how high will oil prices go in a recovery? We lean to the optimistic side on both. We think oil prices could bottom in the second quarter and head up in the second half of 2016. And while the consensus sees oil recovering to $50-$60 a barrel, our year-end estimate is above $75. But selectivity is important. An investor grab for high-quality, low-risk stocks without regard for valuation or risk/reward has created some attractive long-term opportunities elsewhere in the sector, but a number of stocks in this sector will continue to underperform.

Technology. By our analysis, large-cap tech stocks with high return on invested capital are trading at cheap valuations relative to both their history and the broader market, while also generating solid cash. The significant cash balances allow flexibility, and the recent price declines of fast-growing companies may create attractive merger-and-acquisition opportunities.

Health care. Despite current market fears, we’ve found a number of interesting stocks that are attractively priced relative to history and compared to the broader market. Health care also exhibits better growth and is cheaper than other defensive sectors, such as consumer staples and utilities. The sector benefits from favorable demographic tailwinds (namely, the aging of the population) and continued innovation.

Of course, this only scratches the surface. My colleagues and I are excited about the opportunity ahead. Our objective is to work from the bottom up (starting with the individual stocks) to find compelling investment opportunities that are mispriced by the market over a two- to three-year time horizon. We believe the current environment is wildly conducive to that.

While we acknowledge China’s overcapacity and economic weakness, we believe the market was overzealous in pricing in the probability of a U.S. recession. In fact, February and early March have shown a reversal in pessimism … and in markets. This has created some attractive investment opportunities. In our assessment, the period of underperformance has produced some bargains and sets the stage for a rebalancing in favor of value.

Bart Geer is a portfolio manager and head of BlackRock’s Basic Value Team.