Value stocks have underperformed most other styles of investing, as well as the broad market, by a wide margin since the beginning of 2015. We see several reasons why, which point to the catalysts for a potential recovery; we do not think Value is past its prime.
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Historically, stocks with certain characteristics (known as factors), such as Value, Profitable Growth, Income, and Quality, have beaten the broad market over long periods. But stocks with each of these characteristics have followed a distinct performance pattern, doing better or worse at different times.
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In recent years, Value stocks—representing companies that are (arguably) inexpensive due to a short-term controversy—have been cast aside in favor of faster growers. Does this mean that Value investing is past its prime? We don’t think so. We see rational drivers for its underperformance, and a number of catalysts for a comeback.
Since the beginning of 2015, Value has lagged the broader market (Display), while Income, Quality, and particularly Growth stocks have taken the lead. Will the trend continue …or is Value poised for a rebound? Before we can answer, we need to understand the reasons for Value’s recent lackluster results.
The macroeconomic environment shoulders some of the blame. The recovery from the global financial crisis of 2008 (“GFC”) has been marked by low growth and subdued inflation—conditions that favor faster growers. Why? When growth is hard to come by, investors place a premium on companies that can grow through any environment. Facebook, Amazon, and Alphabet (i.e., Google) are current examples.
WHAT DO YOU EXPECT?
The mechanics of Value create headwinds in this environment, too. Value investing seeks to exploit investors’ overreaction to short-term events in the hopes that a company’s stock will revert to fair value once management finds a fix or industry conditions improve. This so-called reversion to the mean has been called into question by slow economic growth and benign inflation. That’s because companies’ future steady state returns may be lower than the historical averages and, for many investors, less rewarding. This has made Value stocks appear less attractive—especially considering the risk that some companies may not get there at all.
Structural shifts in several industries—such as retail, pharmaceuticals, and energy—makes it even more difficult to assess what steady-state returns should look like. Take retail, for example. Department store giants like Macy’s and JCPenney have been struggling, and some view their stocks as a tempting buy. The challenge is determining fair value for the department store of the future when we don’t yet know what the department store industry will look like.
CATALYSTS FOR RECOVERY
Given what we know about why Value has lagged, what kinds of conditions might produce a turnaround?
First, continuing evidence that the global economy remains on a growth trajectory is likely to benefit Value stocks by helping to establish a higher floor for average returns.
Second, normalization of both inflation and, as a result, interest rates would likely turn the tide back toward Value. Higher, but controlled, inflation would likely raise returns on assets because revenue would grow faster than invested capital. This would help capital-intensive value stocks. In addition, financial stocks—which currently represent a large portion of the value universe—should see an earnings uptick as interest rates rise.
Finally, falling interest rates tend to benefit low-risk (noncontroversial) stocks (and bonds) more than (controversial) Value stocks. The reverse is true when rates rise.
While a more favorable macroeconomic landscape should propel many Value stocks, it won’t address the forces of disruption. Affected industries need to finish their makeover and reveal their new look. Only then will investors know where to set the bar—and how to judge a company’s trajectory in relation to it.
For instance, many questions remain about the future of retailing in a world where online shopping has taken greater hold. What is the optimal mix for retailers between online and brick-and-mortar sales? How large should each physical store be, and what should be done with any excess real estate? What will the new profit structure look like and how does a traditional retailer organize in this new world? Until investors get answers, markets are bound to overshoot, and careful analysis will be needed to distinguish the signal from the noise.
RESEARCH POINTS THE WAY
While the market is near historical extremes in terms of the dispersion of returns and value underperformance, there’s no way to tell when the catalysts for a value recovery will take effect. Until then, research can help uncover individual stocks that show promise, regardless of the market environment. Pursuing a balance across Value and all the other factors may also prove beneficial. It can help make a portfolio’s return pattern more consistent and predictable…even if, at times, you hold companies that few others are seeking.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Article by Joseph G. Paul, Cem Inal - Alliance Bernstein