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Viewing value stock potential through a macro lens

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Value investors have been in difficult waters for so long that some have begun to ask whether value investing could be declared dead.

llan Chaitowitz, senior portfolio manager at Nomura Asset Management, says that “over the last five years, growth has outperformed value by around 5% a year”.

Against expectations, value stocks, which seek to profit from companies underpriced relative to their intrinsic value, were also not able to bounce back in the coronavirus crash, according to FTSE Russell indices (see chart below).

Factor performance 1 Jan to 20 May 2020

Source: FTSE Russell, using the following hypothetical (and not live) indexes with a company own tilt methodology: FTSE US, FTSE UK, FTSE Developed Europe ex UK; region: US, UK and EU ex UK

Marlies van Boven, managing director, research and analytics at FTSE Russell, explains to Expert Investor that value was not positioned to benefit from this rotation when looking at the sectors that performed well during the lockdowns.

According to FTSE Russell data, value stocks were overexposed to financials and the oil sector, industries that were hit in the crisis (see chart below).

Sector weights value – 1 Jan to 20 May 2020

Source: FTSE Russell, using the following hypothetical (and not live) indexes with a company own tilt methodology: FTSE US, FTSE UK, FTSE Developed Europe ex UK; region: US, UK and EU ex UK

Meanwhile, quality stocks were overweighted in the technology sector, which was boosted in the downturn (see chart below).

Sector weights quality – 1 Jan to 20 May 2020

Source: FTSE Russell, using the following hypothetical (and not live) indexes with a company own tilt methodology: FTSE US, FTSE UK, FTSE Developed Europe ex UK; region: US, UK and EU ex UK

In the second half of May, however, value stocks did see a bounce back (see chart below), which raises the question whether they could be seeing some upward momentum.

Factor performance 15 May to 31 May 2020

Source: FTSE Russell, using the following hypothetical (and not live) indexes with a company own tilt methodology: FTSE US, FTSE UK, FTSE Developed Europe ex UK; region: US, UK and EU ex UK

Momentum versus value

Van Boven believes that, at some point, value will matter again.

She explains that it is “a risk strategy”, and that these stocks tend to get a boost when sentiment and the economic outlook improves.

“You only take risk when you are a bit more confident.”

While some people have predicted an uptick in Q2, “in the last two years, the trend growth rate was very low”, she says.

At the same time, momentum performed very well in the last few years. This is also reflected in the recent correlation of US Treasury yields with factors (see chart below).

Factor correlation with 10-year US Treasury yields, 1 Jan to 20 May 2020

Source: FTSE Russell

“Everybody has been chasing the momentum. But value and momentum are negatively correlated, so if you are a pure value investor and you missed out on the momentum side, you would have lost a lot of money,” van Boven explains.

This comes, she notes, as currency trends and monetary easing, among other things, have made it difficult to pick stocks based on fundamentals.

Long-term versus short-term trend

Chaitowitz suggests that longer term trends do not support value stocks.

He sees a relationship between long-term interest rates and the relative share price performance of value versus growth.

Low interest rates, including quantitative easing, have led to an outperformance of growth and underperformance of value stocks.

“Even though [governments] were doing their best to prevent a catastrophic outcome of world economies, what they are actually doing is, unintentionally, keeping weaker businesses alive,” he tells Expert Investor.

These “zombie companies” prevented more productive companies from buoying and gaining market share, he believes.

In the normal case, and according to traditional capital cycle theory, businesses with the weakest profitability should either go bankrupt or be acquired by more resilient peers, according to Chaitowitz (see chart below).

The Typical Capital Cycle

Source: Nomura Asset Management

Additionally, the demographics of ageing populations in developed nations and China will weigh on economic growth and interest rates.

Chaitowitz advocates quality as a factor style, as high-quality companies would perform independent from interest rates.

High-quality companies “can typically sustain their returns for longer than the market appreciates and are less likely to suffer irreversible declines in profitability”, he says.

However, in the short-term, he believes that valuation rates “are so low at the moment that one can readily see that there will be some sort of catch up by value funds and value stocks over the next six to 12 months”.

This could explain the recent outperformance of value stocks.

But Chaitowitz alerts investors to interpret this within a broader perspective of “a multi-decade period of lower growth”, and not to expect a strong economic rebound.

Value has significantly underperformed across regions, despite the recent uptick from financials, says van Boven.

“The bounce in financials will have helped the relative performance of value that became extremely cheap,” she adds, while also cautioning value investors to assess stocks carefully, as they could go bust going forward.

Elena Johansson

Senior Reporter

Part of the Mark Allen Group.