Value is dead, long live value!

Key Takeaways

The recent underperformance of value is driven off a very narrow base of tech-related growth stocks. After accounting for Tesla, NVIDIA, AMD, Apple and Amazon, we show that value has largely kept up with the broad market during Covid19.

We believe that the easy monetary environment, and investor complacency with low interest rates have led to the exuberant pricing of growth stocks. Growth stocks are getting pricier, whilst value stocks have remained the same. We cannot see this widening spread as being sustainable.

Introduction

Over the past few months, we have been hearing with increasing intensity and frequency the phrase: ‘value is dead’. Most of the arguments we see are more or less purely descriptive, lamenting the fact that growth has outperformed value in the last few years. However, there is no magic factor that consistently delivers alpha month in, month out. Value, like other styles, is known to have long periods of underperformance, followed by outperformance. Over the long run, value investing works:  there is a plethora of empirical evidence, academic and otherwise, supporting the value premium.

We don’t believe that value investing is dead. Rather, a unique set of circumstances has resulted in the outperformance of a select handful of growth stocks. This outperformance has become increasingly unstable as it is supported by a narrow base of outlier technology stocks, and is fuelled by investor sentiment and easy monetary policy. We believe that the expected future performance of growth is a larger issue than that of value.

First, let us look at performance. The ‘value is dead’ argument largely stems from the underperformance of value relative to other key factors in recent years. In panel A, we show returns of key style factors, illustrating the underperformance of value. In panel B, we plot the rolling 12 month returns over a 25 year window, showing both value and growth styles. We find that the divergence in favour of growth is only a recent phenomenon.

Chart 1. Value, Growth and friends (MSCI DM ex AU from Jan 1995 to Aug 2020)

Panel A. Style returns over different timeframes

Panel B. Rolling 12 month returns between Value (brown) and Growth (blue)

Source: Realindex, MSCI. Return periods indicated by an asterisk are annualized. Data as at 31 August 2020

Value does not equal “Low Quality”

An interesting argument on the decline of value was proposed by Mark Arnold and Jason Orthman from Hyperion in their article ‘Why the Value Anomaly is Dead’. They argue that value is a “fair-weather” strategy that does not perform well in low-growth economic environments.

These authors contend the following: when the economy is expanding and aggregate demand is increasing, there are enough profits for everyone. However, in periods of lower growth, there are only enough profits for the high quality firms, and thus “second best” firms miss out.

The assumption made by these authors is that value picks lower quality firms that don’t have the ability to take market share and compete with their peers. Thus, value relies on the sector growth or the general economy to grow to profit. The argument suggests there is an inverse relationship between aggregate growth and level of competition, and that value stocks prefer economic environments where competition is weak.

The key assumption with this argument is that value is associated with low quality stocks, whilst growth is associated with high quality stocks. This may sound true anecdotally, however, this relationship is driven only by a few large tech stocks from the recent past. When we plot the relationship between quality and value for all MSCI World stocks, the supposed one-to-one relationship between value (growth) and low (high) quality is not as clear as it might seem.

We agree that low quality stocks underperform in poor economic environments. However, this does not translate to the death of value.

Simple growth investing does not equal high quality investing, any more than value equals low quality.

To examine the relationship between value and quality, we have created some scatterplots from stocks in the MSCI World universe. There are many dimensions to quality; here we examine Return on Equity (ROE) uncertainty and leverage (Chart 2). These scatterplots show some interesting relationships between quality, value, market capitalization and sectors.

However, they do not reveal a simplistic one-to-one relationship between quality and value. It is possible to have value stocks with earnings certainty and low leverage, and vice versa, for growth names. This is seen by an almost uniform placement of dots all over the chart. We note that large capitalization names (depicted in Chart 2 by the size of the radius of the dots) may have misled some to believe in a stronger positive correlation between quality and growth.

Chart 2. The Relationship between Value and Quality

Panel A. Value (Growth) vs ROE uncertainty scatterplot

Panel B. Value (Growth) vs Leverage scatterplot

Source: Realindex, MSCI; MSCI World as at August 2020

We note that the recent rise of Information Technology (IT) and Healthcare stocks, especially during the ongoing Covid19 crisis, has helped shape this misconception that growth is synonymous with quality. These are two different but weakly correlated concepts, as shown empirically above.

The role of intangibles

Traditional value strategies, such as using simple book yield, often miss the importance of intangible assets such as intellectual property, accrued through research and development (R&D), and brand power, accumulated through marketing efforts. Over the years, this has become increasingly problematic in developed markets, where profitability are driven largely by intellectual property and intangible assets.

As a consequence, traditional value strategies are often underweight IT and Healthcare sectors; and this has become a key driver to its underperformance. Realindex has adapted to this increasingly important feature of the economy by capitalising R&D and marketing expenses as a way of correcting book value. We notice the biggest improvements in developed markets where intangibles play a larger role.

We at Realindex understand that value investing is constantly evolving.

So whilst we concede that value has its problems, and they need to be continually monitored and evolved, it does not mean that it is dead. On the contrary, we think the recent underperformance in value is driven by the irrational overbidding of select growth stocks. Thus, value is not dead - it is growth that is becoming increasingly unstable. We look at this idea next.

Monetary stimulus has led to exuberant pricing of growth stocks

It’s true that high quality growth stocks have done exceedingly well in the recent past. This is not only due to the rise of intangibles, but also to favourable macroeconomic conditions.

Following the global financial crisis (GFC), there has been an influx of easy money in the developed world. Monetary policy has caused a divergence between firms that can access cheap funding (i.e. high quality firms) vs firms that can’t (low quality firms). This has persisted, which is why low quality firms never get a chance to “mean revert” and outperform their high quality peers. Here we quote Ray Dalio’s article. ¹

Money is free for those who are creditworthy because the investors who are giving it to them are willing to get back less than they give. More specifically investors lending to those who are creditworthy will accept very low or negative interest rates and won’t require having their principal paid back for the foreseeable future. They are doing this because they have an enormous amount of money to invest that has been, and continues to be, pushed on them by central banks that are buying financial assets in their futile attempts to push economic activity and inflation up. […] As a result of this dynamic, the prices of financial assets have gone way up and the future expected returns have gone way down while economic growth and inflation remain sluggish. Those big price rises and the resulting low expected returns are not just true for bonds; they are equally true for equities, private equity, and venture capital, though these assets’ low expected returns are not as apparent as they are for bond investments because these equity-like investments don’t have stated returns the way bonds do […] As a result, their expected returns are left to investors’ imaginations. - Ray Dalio

Growth stocks have more room to accommodate investors’ imaginations, and it is easier for them to get bid up in a market flooded with cheap cash. Their cash flows are more likely to be long dated, and have taken advantage of this low interest rate environment. However, this also makes them more sensitive to interest rate shocks.

Post-GFC, we saw a rise in growth firms as a proportion of the market capitalization index.

In Chart 3, we split stocks in the MSCI World index into quintiles based on Price-to-Book. We plot the first and last quintile, which we label Growth and Value respectively. We find that growth stocks had formed circa 25% of the MSCI World benchmark, however, this year it is at 40%. The value quintile only accounts for circa 10-15% of the benchmark. This has been reasonably consistent over time. This increase in the portion of growth stocks comes in a period of an extended equity market bull run with multiple expansions.

¹“The world has gone mad and the system is broken”, Ray Dalio, 6 November 2019.

Value is opposite of growth. To state that value is dead is almost equivalent of stating that growth stocks will continue to dominate consistently.

Chart 3. Divergence between Value and Growth stocks in the MSCI World index

Source: Realindex, Factset. Data as at 31 August 2020.

What is particularly striking here is that post GFC, the Growth quantile (depicted in chart 4 as ‘low’ book yield) has continuously seen Price to Book (P/B) multiple expansion. The multiple gap between the lowest P/B quantile (i.e., value stocks) versus the highest P/B quantile (i.e., growth stocks) has continuously expanded.

This expansion is attributable to growth stocks becoming “pricier” as opposed to value stocks becoming “cheaper”. This fits with Ray Dalio’s critique that “cheap money” has been flooding equity markets, and especially in growth stocks because they are more able to accommodate investors’ imaginations, where cashflows are more subjective and equity durations are longer.

This P/B expansion in growth names during a period of muted earnings growth suggests the possibility of future weakness in expected returns.

Chart 4. Multiple expansion in Book Yield quantiles - Growth stocks are becoming more and more expensive

Source: Realindex, Data as at 31 August 2020.

The concentration of growth in a handful of names can be shown another way. The distribution of returns between Value and Growth stocks, in 5 year blocks, show a significantly greater right-tail skew for Growth. This has become increasingly unhealthy in the last 10 years as it shows the Growth outperformance has been largely supported by a handful of right-tail stocks which have been bid up significantly higher than the rest of the market. Tesla and NVIDIA come to mind…

Chart 4. The distribution of returns between Value and Growth in the MSCI World

Source: Realindex, Factset, MSCI. Data as at 31 August 2020.

When we zoom in, we can see that this is driven largely by a handful of growth names with relatively large index weights, most of these stocks are in the IT or Consumer Discretionary space.

Chart 5. Growth and Returns in the MSCI World

Source: Realindex, Factset, MSCI. Data as at 31 August 2020.

Therefore, we argue, the question is not whether value is dead, but rather whether this growth rally can continue to sustain itself off such a narrow base.

Value has largely kept up in the Covid19 recovery stage

Many investors have voiced disappointment over the performance of value strategies during the Covid19 recovery. Here we show that the lion’s share of this ‘underperformance’ in the recovery phase is attributable to the outsized performance of a small handful of growth stocks. We isolate five stocks, and show that the value underperformance, relative to the market capitalization benchmark, is largely eradicated once we account for these names.

The five stocks are:

• Tesla
• NVIDIA
• AMD
• Apple
• Amazon

They have, in aggregate, doubled in the last 6 months. In chart 6, we show that a narrow base of technology stocks has been responsible for much of the outperformance in the Covid19 recovery period.

Chart 6. Performance during the Covid19 recovery: Value has kept up if we remove a handful of Tech names

If we remove five tech and consumer discretionary names (i.e., Tesla, NVIDIA, AMD, Apple and Amazon), Value has largely kept up with the broad market capitalisation index.

Source: Realindex, Factset, MSCI. Data as at 12 September 2020

To us, the outperformance of growth looks quite unstable. If we take out a handful of US tech darlings (i.e. Tesla), value has actually kept up with the broad market.

Conclusions

Those saying ‘value is dead’ are implying that growth will continue to outperform. We find that the growth outperformance is being increasing stretched, i) with an extended period of multiple expansion and ii) in recent times, driven off a small base of technology names. We find this to be inherently unstable.

We conclude that:

Value definitions are not perfect, but we’re continually evolving them to incorporate innovation such as our recent change to incorporate intangible assets. 

It is too simplistic to equate “Growth vs Value” with “high Quality vs low Quality”.

The Growth-Value spread is in part due to monetary stimulus, with easy money flowing into growth stocks, stretching their implied equity duration and increasing their multiples relative to value names. This seems inherently unstable and is driven off a narrow base of technology firms. Therefore, it should be questioned whether or not this can continue.

Disclaimer

This material has been prepared and issued by First Sentier Investors Realindex Pty Ltd (ABN 24 133 312 017, AFSL 335381) (Realindex). Realindex forms part of First Sentier Investors, a global asset management business. First Sentier Investors is ultimately owned by Mitsubishi UFJ Financial Group, Inc (MUFG), a global financial group.

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