"The fundamental backdrop for Value returns has been especially unfriendly in recent years, but these conditions are unlikely to persist (and are already moderating)."
- Ben Snider, Goldman Sachs Equity Strategist
Value investing has been a tried and tested approach for superior, long-term returns. In February, this column commented on the powerful comeback of value investing in 2016. Value stocks substantially outperformed growth stocks (and market indices) across all classifications: Large companies, small companies, American, international. For example, U.S. value stocks rose 17 percent while U.S. growth stocks gained only 5 percent. Funds focused on the best value stocks did even better.
In that February article, we also posed the question: Will value continue to outperform?
"History suggests the answer is "yes". Before 2016, there were six big turning points where value switched from underperformance to outperformance. Each of these winning stretches for value lasted more than 24 months. In the current cycle, value's turn started in mid-2016, so the trend seems likely to last quite a while longer. Indeed, if key macro forces such as inflation and interest rates continue to rise, value stocks may be poised for a good multi-year run... But value stocks didn't go up in a straight line — markets remained choppy."
How has 2017 played out thus far? In the U.S., the Russell 1000 Growth Index outperformed its value stock counterpart by 10 percentage points in the first half. Globally, value lagged behind growth by about 7 percent. So, growth has substantially outperformed value in 2017 to date.
To understand this better, it is helpful to look at the key macro drivers: Expectations around inflation and interest rates. As a general principle, artificially low interest rates tend to fuel speculation as money flows into glamorous, momentum stocks. In contrast, normalized interest rates tend to make asset prices more rational. Overvalued high-fliers come back to earth, and value stocks rise toward fair prices.
In late 2016 and first couple months of 2017, markets showed signs of a return to rationality. The new pro-business administration promising tax cuts and infrastructure spending all fueled expectations of rising inflation and interest rates. This helped fuel a surge in value stocks, many of which were concentrated in the natural resources and financial sectors.
But following the weakest first-quarter economic growth in three years, this bullishness in value stocks receded as first-quarter earnings reports underwhelmed and much of the pro-business agenda seems to have stalled in Washington. Interest rates (as measured by the 10 year bond yield) actually declined, as did inflation expectations. Speculative fervor has return as money has surged into highly valued growth stocks such as Netflix and Tesla, and out of value stocks.
Will value investing comeback resume after this setback? Looking at the bigger picture, the answer is still yes, and conviction is getting stronger.
First, we are at valuation extremes. Growth stocks are the most expensive, as they've been relative to value stocks since the height of the dotcom bubble in 1999. Growth stocks, especially technology high-fliers such as Tesla and Netflix, are priced for perfection. Meanwhile, many value sectors such as commodities, are at generational lows. This extreme gap should close.
Second, interest rates and inflation seem likely to move higher. As Europe's economy recovers, its central bank may soon exit its perverse negative interest rate policy. This in turn, will push up U.S. interest rates also. Commodity prices — industrial, energy, agricultural — seem to have bottomed out after their deflationary decline over the last five years. Government policies — including tax cuts and higher military and social spending — also suggest higher rates and inflation will be on the way.
The above factors bolster our confidence that value investing should resume its outperformance. But market sentiment is fickle and volatile. That's why we are advocates of dollar cost averaging. By steadily, systematically adding to holdings, investors can exploit the market volatility along the way.
Jonathon Fite is a Managing Partner of KMF Investments, a Texas-based pure pay-for-performance hedge fund. Jonathon is also a lecturer with the College of Business at the University of North Texas. This column is provided for general interest only and should not be construed as a solicitation or as personal investment advice. Comments may be sent to email@KMFInvestments.com.