One of the anomalies of the equity market over the past few years is that value stocks have underperformed growth. For the best part of the last century, buying stocks that were cheap was the best way to make gains. But not in recent times.
Fund manager Simon Adler believes the current situation, where value stocks are underperforming, will not last and investors have a great opportunity to buy value ahead of their recover.
Adler, who is co-manager of value and ESG portfolios at Schroders, says: “Value has underperformed because of low interest rates. The change in the discount rate resulting from low rates favours growth stocks because it leads to much higher valuations on those stocks.”
Adler is buying European banks for his “deep value” portfolio. He says the valuations are attractive and he is not concerned that the banks might be a value trap. Some of those holdings include Standard Chartered, Royal Bank of Scotland, Barclays and UniCredit.
“They are trading at discounts to their NTA, dividend yields are high and they are on low Pes. They have very high capital holdings.”
His fund is also investing in oil and gas stocks and some other commodity producers, which he says are cheap.
In September there was a global “value rally”. Adler cannot say whether that is the beginning of a long-term change in market dynamics
Adler is not the only fund manager pointing to the opportunity in value stocks.
Reece Birtles, the chief investment officer of fund manager Martin Currie Australia, says value stocks are more cyclical in nature, with earnings aligned with the economic cycle. Growth stocks tend to grow “on their own”, with depending on the economic cycle to drive earnings growth.
Birtles says that over the past couple of years growth stocks have outperformed because investors have been willing to pay much more for growth.
“A typical PE [price-earnings multiple] for growth is 25 times, while a typical PE for value is 12 times. Growth is currently at 40 times, while value is still at 12 times. The ‘value spread’ is very wide,” he says.
“That is about expected growth. People will pay for stocks that will grow earnings even if the economy falters.
“Our view has been that there is a distortion in this. Everyone is betting growth, assuming the economy will continue to weaken. We think the economic stress is not that bad.
“In September we saw that start to change and our view is that over the next three years we will see the value spread narrow.”
Value stocks are typically found in cyclical sectors, consumer staples, financials and energy. Birtles says he is overweight energy and is investing in cyclical and consumer staples.
Another manager supporting the value bounce thesis is DNR Capital. In the September investor report for its Australian Equities High Conviction Fund it says that for the past year momentum has been with defensive and growth stocks but in September that was “a rotation to value”.
Sectors like health, information technology and REITs struggled in September, while resources, banks and energy stocks performed better.
“Despite the rotation, momentum stocks are still trading at high valuations, which suggests the rotation can continue if external events continue to be supportive,” DNR says.
“The past decade has been an odd bull market. Driven by quantitative easing and low interest rates, nervous investors have gravitated to defensive and growth companies in an uncertain world. Stocks with perceived risks or cyclical exposure are trading cheaply.
“A rotation to these stocks would likely accelerate if the market becomes convinced that the recent economic softness is turning. We have seen stimulus in the form of lower interest rates across the globe and some modest fiscal stimulus in some markets.”
DNR is overweight de-rated quality stocks where it believes the market’s concerns are “overcooked’. These include James Hardie Industries.
And it is overweight companies that it believes have “improving quality characteristics”, such as WorleyParsons.
Birtles says: “A key reason why value typically outperforms growth in the long run is value’s superior earnings per share (EPS) growth relative to growth stocks. Investors have a bias towards trend extrapolation and over-optimism of future EPS, but the reality is that paying more for an unmet expectation doesn’t add value, and value’s fundamentals prevail in the end.
“The continued trend of superior EPS, despite poor value style performance in the last few years, gives us confidence that the value style works when the market focuses on underlying fundamentals.”