Destination value – one return ticket, please

Duration:00:05:54

• While value stocks had underperformed growth stocks for a number of years, the tide seemed to be turning.
• With the election of Donald Trump it looked like value investing was finally making a comeback, but it was not to last long.
• Trump’s failure to deliver on his promises, and more importantly on health and tax reform, has pushed out the hopes of accelerated economic growth.
• There are plenty of curve balls which could fuel a further shift away from value.
• Yet we believe that intrinsic value is a magnet from which an equity value cannot stray too far for too long.

Value stocks, defined as those trading on cheaper valuation multiples, had started to outperform growth stocks from the beginning of January 2016, following two years of underperformance within an eight year secular trend of relative weakness. This trend persisted quite nicely through November 2016, as economic growth prospects in the US gradually improved, fanning the flames of anticipation for higher interest rates and rising inflation. The “surprise” election of Donald Trump as President of the United States threw oil onto the fire, and value stocks roared ahead into the year-end, led by financials, industrials, telecom services and energy. Expectations and hopes were high, with a lot riding on Trump’s “reflationist” agenda to break the US free from the shackles of low interest rates, deflation and sluggish economic growth. It looked like value investing was finally making a comeback.

But boy, was that short-lived? Figure 1 shows the relative performance of the Russell 1000 Value Index versus the Russell 1000 Growth Index.

The Russell 1000 Value Index consists of the stocks with the lowest price-to-book ratios and lowest forecasted growth rates, while the Russell 1000 Growth Index consists of the highest price-to-book ratios and forecasted growth rates.

Value stocks reached new lows

Since the peak in relative performance achieved at the end of 2016, the value Index has given up all its relative performance since Trump’s election. In fact, the index has given back all its relative performance since the start of the value run in early 2016, and, in doing, so has broken new lows. It seems that the recovery in value stocks was a temporary blip at best in the long-term secular trend for growth stock outperformance. 

Is that a fair conclusion? Well, one of the drivers of the cycle for growth stocks has been the dearth or scarcity of growth in general. This is intricately linked with the low long-term US bond yields and low interest rates. The combination of growth scarcity and unattractive bond yields has led investors to flock to companies with more predictable growth, and they have been willing to pay higher valuations for this certainty. Interest in stocks trading below intrinsic value fell to the wayside and the market’s appetite for risk has shrunk significantly.

Trump brought hope of economic growth

Trump brought hope of economic growth via stimulus and reflation, and that made value stocks extremely attractive relative to growth as they were priced for little to no growth into the indefinite future. But Trump’s failure to deliver on his promises, and more importantly on health and tax reform, has pushed out the hopes of accelerated economic growth. Bond yields, having leapt higher after the election, have started to retrace the move (though they are still above 2%) while the yield curve has flattened to below levels seen prior to the election. As expectations for GDP growth and interest rate hikes were reined in, the stock market - while marching higher in aggregate - punished value and favoured growth. As it stands today, it is as if the election never even happened.

Year-to-date (as at 2 June 2017), tech has trounced the market’s returns with energy, financials and telecom services bringing up the rear. Valuations of the tech sector are high in places but not across the board, and levels are still nowhere near to the extremes of the 2000 bubble - if that is the benchmark. The question now is whether this divergence of performance between value and growth is deserved. We believe not, but recognise that the market could get more distended before reverting back to the mean.

Trump or no Trump, the economy was progressing nicely

Trump or no Trump, the economy was progressing nicely. Rates were rising, supported by strong employment growth. Industrial activity was picking up after a brief lull, and wages were starting to rise at an accelerating pace. Housing starts continued to recover, with plenty of room for more growth, while housing prices have risen. The backdrop was and still is constructive for value. Trump’s failures so far have only delayed the prospects of lower taxes, infrastructure stimulus, and deregulation - but they are still likely to occur in some form or another. And right now it seems the market is no longer pricing in any benefit from such policy actions, with investor sentiment towards economic growth at extreme lows. Interestingly, the US credit market has also remained stable, showing no real signs of stress. Spreads between US corporate bonds rated Baa3 (Moody) and the US Government 10 year Treasury yield remain at relatively benign levels (see Figure 2).

There is certainly some cause for concern over the economic outlook based on weak consumer spending trends in 1Q17, and credit issues materialising in the auto-loans market. Are these early indicators of economic peril? Perhaps, but it is certainly too early to say. 1Q17 experienced a number of headwinds to consumer spending, creating a perfect storm if you will: tax refunds were delayed and paid much later than normal; weather was challenging; and Easter was later this year, falling into 2Q. On auto-loans, the credit losses are indeed rising - but from a very low base. So far the evidence suggests we are just in the early stages of a credit normalisation, as opposed to a spiralling credit problem.

An immediate US recession is currently unlikely

Cornerstone Macro, a strategy research company, publishes a predictive model for the probability of recession in the US - and while the probability is rising, it is far from levels that would typically coincide with contraction (see Figure 3).

Our sense is that the market has, once again, pushed the extremes of sentiment and the prospects are high for a reversal. We note too that the Citigroup Economic Surprise Index, which shows how economic data are progressing relative to the consensus forecasts of market expectations, looks poised to rise once more after a steep decline (see Figure 4).

What gives us more hope is that value has been working outside of the US, despite the roll-over in performance domestically, as can be seen in Figure 5 from Morgan Stanley. This signifies potential for value stocks to regain their footing as the roll-over has been more about strong performance in growth stocks rather than weakness in value stocks.

Value stocks have the potential to regain their footing

Of course, there are plenty of potential “curve balls” that can be thrown at the market, such as a Trump impeachment, the UK General Election, and the Chinese economy. Any of these could potentially fuel a further shift away from value investing, and potentially on a more global basis. As ever, investors need to be nimble, but regardless of the future path, we hold firm to our belief in the long-term merits of buying stocks for less than their intrinsic values.

Intrinsic value is a magnet from which an equity value cannot stray too far for too long.

Important information

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Where Simon Clinch has expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals