These are trying times for value investors. By some measures, value stocks have experienced the longest and deepest period of underperformance on record. We are acutely aware of value’s challenges in the current environment. Indeed, by some measures the value trade is the least “crowded” it’s ever been, making a value bias today about as contrarian as it gets. Yet, in our view, it is this extreme positioning that primes the market for the kind of snap-back in value that we saw briefly during the first quarter of 2016 (after seven consecutive quarters of value underperformance). Ultimately, we believe that value has simply gotten too cheap, and that recent choppy trading could mark a transitional period as value finds a bottom and lays the groundwork for sustainable recovery. Of course, there is a risk that value securities may not increase in price as anticipated or may decline further in value.
The reasons for value’s underperformance are well-known by now. In recent years, value indices have been full of volatile, often leveraged, stocks in cyclically depressed sectors like energy, materials and financials. Companies based in emerging markets – or with high exposure to emerging markets prone to boom-bust cycles – have also populated value indices as growth contracts and margins erode in these end-markets. More recently (over the last several quarters), we have seen the valuation extremes long evident in deep cyclical sectors spreading more widely. Across the market, the gulf between the cheapest and most expensive stocks on most major valuation metrics within sectors has widened. For example, value is just as cheap today within pharmaceuticals and biotech as it is within financials and energy. The spread of value to many different sectors and regions may enhance the style’s appeal in the eyes of the generalist investor, helping perpetuate the potential for value recovery. Yet, for now, value remains unpopular against a backdrop of low growth, paltry yields, excessive debt, and heightened uncertainty. What has been popular are stocks with strong balance sheets, high dividend yields, low beta (a measure of volatility relative to the market), countercyclical growth prospects and exposure to the relatively resilient U.S. economy.
We understand this, and are not arguing it should be otherwise; growth should attract a premium in a low-growth environment, stability should attract a premium in an uncertain environment, yield should attract a premium in a zero interest rate environment. But, everything has a price. High quality stocks (defined as stocks generating consistently high return on equity) are nearly 8x more expensive than stocks generating lower returns. Prior to the global financial crisis, high quality stocks were just 2-3x more expensive. The price-to-tangible book discount of global value stocks (as represented by the MSCI World Value Index) relative to global growth stocks (as represented by the MSCI World Growth Index) is more than two standard deviations¹ greater than normal, exceeding even the value gap that emerged during the technology, media and telecom bubble in 2000.
Citigroup’s equity strategist, Robert Buckland, recently identified three preconditions necessary for asset bubble formation: a new paradigm story, surplus liquidity and a supply and demand imbalance. As there was with tech stocks in the late ‘90s, we would argue that today there is a bubble in “safe” assets, creating extreme overvaluation among growth and quality stocks and extreme undervaluation among cheaper, more volatile stocks. This time around, the new paradigm is secular stagnation and the surplus liquidity has been provided by central banks in the form of quantitative easing. The type of “safe” securities many investors demand today are also in short supply, with negative yields spreading and the number of non-financial sector companies rated AAA by S&P Global Ratings in the U.S. falling to just two down from 60 in 1980.
In this environment, many investors think that value doesn’t stand a chance. We’ve argued to the contrary, suggesting that an eventual rise in interest rates and the mean-reverting tendency of valuation extremes should support value over our long-term horizon. One of the biggest counter-arguments we have faced is that rising interest rates don’t cause value outperformance, they merely reflect a stronger economy and building inflationary pressures, themselves the primary catalysts for value. While we agree that economic recovery has been an important driver of value in the past, it is by no means a precondition for a value rebound. For example, investors waiting for an improving economic cycle would have missed the value upturn in 2000. On the other hand, investors fleeing value in anticipation of economic weakness would have missed value’s outperformance during the recession of 1981–1982. In each of these instances, we believe value stocks simply became too cheap, and mean reversion prompted a value rally. The point is that while value can be pro-cyclically correlated to the economy, this isn’t always the case. We consider the starting point valuation of value stocks (or any style factor, for that matter) to be a far more accurate predictor of future returns than the outlook for economic growth. Not only that, but starting point valuations are knowable, unlike future economic growth. When it comes to value, today’s valuation starting point is distinctly compelling, in our view.
Norm Boersma is chief investment officer at Templeton Global Equity Group.
Cindy Sweeting is director of portfolio management at Templeton Global Equity Group.
Heather Arnold is director of research at Templeton Global Equity Group.