Economic recovery hopes bring optimism back to value investors

Economic recovery

Value investing could see a revival as economic activity picks up in the wake of the Covid-19 pandemic, as asset managers predict that lowly-rated stocks could outperform in the upturn.

The value investing strategy, which seeks to invest in companies that are undervalued by the market, has fallen firmly out of fashion in recent years as big tech ‘growth’ stocks like Facebook, Apple, and Amazon have taken over the large-cap equities indexes. 

Over the past 25 years, growth funds have outperformed value funds, returning an average of 1,072 per cent, versus a more meagre 624 per cent for value funds, according to research from CAMRADATA.

Brian Jacobsen, chief portfolio strategist at Wells Fargo Asset Management, says that value investing pays off in periods of economic instability. He notes that some of the strongest returns for value investing were made in the aftermath of the tech bubble, which burst in the early 2000s. 

A period of swift recovery following the sharp market downturns in March could put value investors on the front foot, according to Jacobsen. If this happens, “the value strategy will likely outperform large-cap growth, which has been dominating for the last business cycle”.

He admits it hasn’t been an easy ride for value investors in recent years. “A lot of people have been asking in the past decade what in the world has happened to the value premium? Where has it gone? There’s actually been more of a value deficit rather than a value premium over the last 20 years.”

He says that the so-called Great Moderation that began in the mid-1980s and lasted through to the early 2000s reduced the volatility of business cycle fluctuations in developed nations – but that this was actually a thorn in the side of value stocks.

“We just got done with an economic expansion that was characterised by slow and stable growth and low, stable inflation, and those aren’t conditions where the value premium really shines. It’s typically around the turning points or periods when you have more volatile or unstable growth and volatile or unstable inflation that the value premium is positive.” 

He views the US economy as the most promising in the short term, since it is set for a “more aggressive recovery” that will see activity bounce back to pre-pandemic levels by the beginning to middle of 2021. “Everybody went down together but not everybody is likely to rise together,” says Jacobsen. 

China will be the first to get back to pre-Covid levels of economic activity, likely before the end of 2020, he predicts. Meanwhile, he says the Eurozone and the UK are likely to take longer, with the recovery stretching out to the end of 2021. 

He adds that American value investors may see greater returns from investing in European stocks if the dollar continues to weaken.

As for sectors within traditional value stocks that could benefit, investment managers at Walter Scott, a BNY Mellon subsidiary, have tipped oil and gas as a sector to watch as transport gets going and more people drive to work and start to fly again.

Oil and gas equities have lagged markedly of late, generating the weakest returns of any sector in the S&P 500 in 2019, as climate change weighed more heavily on investors.

Dominic Wallington, head of the European Equity team at RBC Global Asset Management, argues that although in the short term, an economic recovery may boost value stocks since “a rising tide lifts all boats”, it is “not sufficient” for the defenders of value investing to blame its poor performance on the lack of underlying economic growth in recent years.

Slow economic growth is “one of those metrics that people grab because they're looking for a kind of macro explanation for what's going on,” he says. 

According to Wallington, the “master narrative” at play is technology. “The economic value of many of these companies that are labelled as value companies has been collapsing, and therefore the value that appears to exist is a mirage.”

He gives the example of traditional retail companies, that are “really facing a stark period of time” if they are not supple enough to embrace technology. Those that are? “Online clothing retailer Asos is talking about growth of 17 to 19 per cent for the year against a retail landscape that is collapsing,” he notes.

Wallington compares it to the transport boom created by railways in the 19th century, where technology is pushing things forward for commerce generally. “It’s not just about tech, it's about the impact of tech,” says Wallington. 

“There are all sorts of sectors and types of companies that are supple and can use facets of technological development in order to create their own growth, and they have tended to do really quite well. It’s that group that people are now beginning to call growth companies and all of the companies that have had negative disruption that they're beginning to call them value companies.”

According to Wallington, there is a widening gulf between companies that can keep up with the pace of change, and those that can’t. “I think the thing that we need to throw away is this idea that all companies are the same, and that therefore value is available to the cheapest company. And anything that's expensively rated is therefore not value.” 

By mid-May, forward price-earnings (PE) ratios for the Russell 1000 Growth index were at 27.8x, compared with 19.2x for the Russell 1000 Value index.

“Some companies deserve a very, very high rating,” but Wallington says they are very rare. 

On the other hand, Spanish asset manager and value investor Azvalor writes in its latest quarterly investor letter that there is an “eternal temptation among many investors to justify high prices with narratives about paradigm shifts, something that has cost them dearly several times throughout history”. 

The extremely high valuations currently commanded by big tech companies will “come to a bad end”, and the growth investing spree will eventually have to roll over, according to Azvalor.

Apple recently became the first US company to be valued at USD2 trillion after its share price hit USD467.77, just two years after becoming the world’s first trillion-dollar company in 2018.

“One repeated argument is that today’s tech monopolies (Amazon, Facebook, Google, Netflix) are different this time as they have barriers to entry, access to a “gold mine” of valuable consumer data, financial lungs in the form of great sums of cash and a certain affinity with the governments in power. 

“All of this is true”, but Azvalor notes that historically no companies have been able to cope with “such a strong over-valuation beyond a few years”. 

“As a class, we are certain that it will come to a bad end, without prejudice to some companies eventually escaping (perhaps only partially) the major falls in their share price from current levels.”