17 Nov 2023
Who can argue that value investing doesn’t make sense? Buying cheap assets and selling them at a higher price is what investing is all about.
But the debate continues over value versus growth stocks. There are many ways to identify which assets are likely to rise in value and they don’t necessarily involve buying the cheapest assets.
History has shown that different styles might outperform depending on market conditions. Traditionally when bond yields fall, growth stocks have performed well, while value stocks have been known to outperform in the early stages of economic and market cycles (when bond yields rise).
So, where are we now? I believe the decades long downtrend in bond yields (and outperformance of growth stocks) is over, which could favour value stocks. But let’s take a look at history first.
When I started my career in the mid-1980s, it was easy to prefer assets that were selling on low valuation multiples. Back tests suggested that value investing had produced higher returns than other methods such as favouring growth.
However, things started to go wrong for value investors in the second half of the 1990s when the internet bubble drove technology and other growth stocks to unsustainable levels. Of course, the bubble eventually burst but careers were ruined among value investors who were relieved of their duties before they were proved right.
Unfortunately, the joy didn’t last, and value has underperformed growth for much of the post-global financial crisis (GFC) era. Casual observation suggests that falling bond yields were an important part of that process – in theory, the lower the prevailing bond yield, the lower the discount factor applied to future earnings/dividends and the higher the premium applied to growth (such stocks are long duration instruments, with an above average share of value contained in the distant future). As bond yields were trending lower for much of the past three decades, it should come as no surprise that growth investing has risen in popularity at the expense of value.
Those working in the financial industry since the start of this century may be forgiven for believing that bond yields always fall and that growth stocks always outperform. However, we have now seen that bond yields can rise (and rise sharply) and 2022 showed that the value factor can outperform growth (and other factors). In fact, I believe that the downtrend in bond yields is now over, and I would expect something approaching normal cyclical variation, especially as central bank asset sales reduce the dampening effect of quantitative easing (QE) on yields. Hence, I expect a more level playing field between growth and value than we have seen over recent decades – some phases of the economic cycle will favour growth, and some will favour value (our analysis shows that value typically outperforms other factors at the start of an economic and market cycle).
However, 2023 has not followed the script that we might have expected. Though our value factor index has outperformed growth in Europe, it has underperformed growth in the US (and all other factors except low volatility). Despite the rise in bond yields, growth has been the best performing factor in the US, though in Europe it has underperformed all factors except size. I believe the strong performance of growth in the US is explained by the emergence of artificial intelligence (AI) tools, which has boosted technology stocks in the US.
I doubt that AI can continue to distort market performance in the way that it has done throughout 2023, especially as it is now common to hear that investors are seeking ways to mitigate the concentration risks that come with market capitalisation weighted indices such as the S&P 500. Talking of which, my analysis of US stock returns since 1881 suggests that long term returns tend to be the highest when the starting point is low valuation multiples and the lowest when such multiples are extended, as they are now (using the Shiller PE as the valuation metric). I view that as one proof that buying cheap assets generates better returns over the long haul.
It is my belief that equity markets have not yet fully adapted to the rise in bond yields, based on the fact that growth stocks have held up so well. Apart from the AI phenomenon, this may also reflect the fact that many investors have only worked in an environment where growth outperforms and that it may take a while for them to accept that other outcomes are possible. This could be a painful process of disappointment with growth over a number of years, as higher hurdle rates of return have their effect. In the meantime, value may perform better relative to growth than might otherwise be expected.
I don’t, however, think this will be a straight-line process. I would expect value to be strongest in the early stages of economic and market cycles and to outperform growth, in particular, when bond yields are rising (which is often in those recovery phases). The bad news is that I expect major Western central banks to commence policy easing during 2024, which could herald a decline in long-term bond yields. That may boost growth stocks relative to value but I think it would be short lived. Also, as outlined above, I think that value is better value than growth at the moment, especially in the US, so wouldn’t be surprised to see value outperform over the medium term.
I am a strong believer that the major determinant of returns in a portfolio is the price paid for the assets (buy low/sell high!). Hence, I am temperamentally a value investor and believe that the decades long downtrend in bond yields is finally over, which suggests the permanent tailwind for growth stocks is a thing of the past. As growth stocks adjust to that new reality, I expect value investing to enjoy a renaissance.
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.
Data as at 17th October.
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Views and opinions are based on current market conditions and are subject to change.