26 August 2020
The evolution of valuation metrics in determining whether a company’s stock is cheap or expensive is a topic we explored in “Evolve or perish: The evolution of company valuation,” which included discussion of the shortcomings of book yield in the post-digital era. Now we turn to the recent relative underperformance of value stocks and provide our views on their outlook: Will value be great again?
Value stocks are generally defined as stocks in the top third of an investment universe, sorted by book-to-market (for example, book yield). Practitioners commonly use a more holistic definition, combining a set of yield metrics – such as earnings yield, book yield, dividend yield, and free cash flow yield – into a composite factor. The opposite of value is typically defined as growth.
A much-talked-about theme in recent years has been the underperformance of value stocks versus growth stocks, which is a reversal of value stocks’ dominant performance over prior decades.
Rebased index values of MSCI World Index, MSCI World Value Index, and MSCI World Growth Index (in US dollars, net total return), from 2010
Rebased index values of MSCI World Index, MSCI World Value Index, and MSCI World Growth Index (in US dollars, net total return), from 1980
The impact of interest rates on growth and value stocks
In recent years, value outperformed growth when interest rates were rising. This can be explained through a discounted cash flow model:
Where p is valuation of a stock, et is earnings at year t, γ is payout ratio, and κ is cost of equity.
From the model, we make two observations:
- Growth stocks are valued on future cash flows that have a lower value under higher interest rates.
- Rising interest rates tend to indicate a strengthening economy, which is favourable for cyclical sectors that tend to be more value-focused, including banks, building materials, consumer discretionary, and media.
This value-up/growth-down theme played out in September and October 2019 and also in the fourth quarter of 2018 when growth/quality stocks struggled.
Following this line of thinking, it is no surprise to us that value struggled for most of the 2010s, coinciding with an extended period of falling interest rates and subdued global economic growth.
Global debt levels were high prior to the COVID-19 pandemic and have ballooned since, suggesting that interest rates will need to be managed at low levels by central banks for an extended period, creating potential headwinds for the value style.
COVID-19’s effects on a pure value approach
We believe there is considerable uncertainty in the outlook for value. If a stock is cheap because of an excessive equity risk premium, then we can reasonably expect the premium (defined as the cost of equity in excess of the risk-free rate) to eventually dissipate, and value managers who buy the stock should do well.
However, if a stock is cheap because the company’s earnings trajectory is permanently lower, then it is generally unlikely to revert. For many of the current “cheap” stocks (such as tourism and brick-and-mortar retailers), it is likely these companies have seen their earnings trajectory permanently lowered, at least in the medium term.
Put another way, we see the current value stocks as those facing structural challenges from which we believe recovery will be hard. As such, we do not believe the current environment is conducive to the outperformance of value.
Even prior to the coronavirus outbreak, earnings revisions for value companies tended to be lower or negative compared with growth companies, reinforcing the observations of structural issues challenging some of these companies.
From a quantitative perspective, value as a factor requires the re-rating and convergence of cheap and expensive stocks – via cheap stocks becoming more expensive or expensive stocks becoming cheaper.
The chart below shows the quintile spreads for earnings yield / earnings-per-share (EPS) growth. Of course, in the current environment, additional challenges with estimating 1-year forward earnings must also be considered. Although there was a temporary spike in this dispersion, we have since seen levels come back in line with historical norms.
Rolling earnings yield: 12 months forward cross-sectional dispersion (top 80% - bottom 20%) for the MSCI World Index universe
Sources: Bloomberg, Macquarie Investment Management.
Such behaviour illustrates that sentiment effects can become dislocated during periods of uncertainty. The period of uncertainty is then typically followed by a period of recalibration. It is during these periods that the sentiment factor is less effective, as investor behavioural biases shift away from chasing winners and into a more defensive approach to stock picking.
Diversification and multifactor exposures
Attempting to time the market is inherently difficult, if not impossible. We believe that taking a more diversified approach to investing and using multifactor exposures (that is, value, quality, and sentiment factors) to help drive returns is more prudent.
In our view, this helps position investors to benefit from a recovery in value without relying on a single outcome to deliver excess returns. From our experience, we believe that this approach can work, ultimately delivering the potential for more consistent returns throughout the market cycle.