It has been very difficult to be a value manager over the past decade. The value style has endured a long period of underperformance across global equities that began just before the global financial crisis.
According to global asset manager Schroders, between the start of 2007 and the end of 2017 the annualised underperformance of value relative to growth in the US has been 1.5%.
While this paints a pretty poor picture for value as a style, investors should however be aware of the longer-term story. If one extends the period under review all the way back to 1927, value has outperformed growth by 3% per year.
If one looks at the year-by-year performance of the MSCI World Value Index compared to that of the MSCI World Growth Index, growth has only outperformed value in 17 of the 42 years since 1975. Eight of those instances have occurred since 2006.
“The most recent 11 years have been pretty woeful,” says Tom Mann, portfolio manager at Schroders. “There was only one decent year for value in 2016, which was driven particularly by an improvement in oil prices that helped the energy sector.”
However, he argues that there are very clear reasons why this has been the case.
Over this period the world has seen very low inflation and interest rates, yields on government bonds have been depressed, and central banks have resorted to stimulating economies through quantitative easing. Portugal, Ireland and Greece all had to be bailed out over this period, and China’s GDP growth rate has slowed from over 12% to around 6%.
“From an economic perspective, this hasn’t been a great place to be,” says Mann. “Growth has been scarce, and when something gets scarce its price gets bid up. That’s been the case with the FAANG stocks – Facebook, Apple, Amazon, Netflix and Google (Alphabet) – they are very rare growth assets that have been bid up because of the lack of growth elsewhere.”
The other stocks that have been in favour are defensive equities that pay consistent dividends. This is because bond yields have been so low that investors looking for income have moved into these shares that have effectively been paying more than fixed income instruments.
The macro picture
Investors should however consider how this environment is changing. Azad Zangana, senior European economist and strategist at Schroders, argues that the global economy is moving into a new, expansionary phase.
“It’s a very positive story generally on economic growth worldwide,” Zangana says. “Industrial production is now rising and we have very clear signals that inflation is picking up.”
The US Federal Reserve has started raising interest rates, and the European Central Bank is likely to do the same next year. This creates a very different picture for investors.
“You can clearly identify periods in the economic cycle where you should want to be buying value over growth and I believe that we are approaching that kind of period,” Zangana says.
Growth stocks are no longer so precious, since good company earnings growth is becoming the norm rather than the exception. At the same time with interest rates going up, income investors are returning to bonds.
Catalysts for change
Mann believes that there are three likely catalysts that will see value once again starting to outperform.
“The first is that growth companies potentially start to miss their earnings expectations,” he says.
As the valuations on some of these stocks are already so stretched, this is an obvious first place to look. A Schroders model suggests that the most expensive 20% of the market is trading at multiples that imply that the market is expecting 36% earnings growth per year over the next five years.
“The market cap of Facebook at Monday’s close was $538 billion dollars,” says Mann. “If you grow that at 36% per year over five years that becomes $2.5 trillion dollars. US GDP is $19.3 trillion. So if that number for Facebook is correct, you are expecting it to grow to become 13% of the overall US economy.”
The second catalyst would be the opposite – that value stocks start to beat market expectations for earnings. This would see their prices rerating.
“An example is Shell,” Mann says. “It hasn’t been great recently, and halfway through last year you could have bought shares in London for £20. It’s currently trading at £22.70 after a number of quarterly earnings releases showing better revenue, costs and cash flow. Over the same period Shell paid you close to a 6% dividend yield. That’s a 16% return from a stock where market expectations were extremely low.”
The third is a rise in corporate activity in the forms of mergers and acquisitions.
“Investors tend to think that all players in the market are similar to us – it’s just investors buying and selling shares,” says Mann. “You don’t tend to think that we are operating in the same market as industrial buyers too. Other companies can see cheap assets, and if its cheap enough they can come and buy it.”
Mann believes that there is good reason to believe that these elements are already starting to play out.
“As investors we have the opportunity to do a number of things,” he says. “We can buy and carry on holding the growth names that have delivered strong earnings growth, but need to continue to deliver, or we can buy stocks were expectations are extremely low. I would argue that there is a strong proposition for the latter.”