Before and After1
Following a long period of underperformance, the value style has finally started to deliver strong returns. The drought has broken; long may it continue.
Since November 2020, we have seen a strong and consistent rebound of the value style, while growth and momentum styles have trailed behind (Table 1).
Table 1. MSCI Value and Growth Index Performance
Source: Factset, Realindex, data as at 31 March 2021
This can be seen in the largest outperformers in the MSCI ACWI universe in the six months between April 2020 and September 2020, compared to October 2020 to March 2021 (Chart 1). In the first period, when growth was performing very strongly, the bulk of the returns we driven by large gains for stocks in the classic growth sectors of Tech and Communications Services (Tesla > 300%, Zoom > 200%, Square > 200%, plus large moves in PayPal and NVIDIA). The second period is marked by smaller and more broad-based return drivers, in the more core value-type sectors of Industrials, Energy and Financials.
Chart 1. MSCI ACWI Total Returns by Company
31st March to 30th September, 2020
30th September, 2020 to 31st March, 2021
Source: MSCI, Realindex, data as at 31 March 2021
Drivers and Outcomes
For many years following the Global Financial Crisis (GFC), value underperformed growth. There are a number of possible explanations for this, but central among them have been:
1 Low real interest rates. These should be stimulatory to the economy, but have largely failed in this endeavour. Also, low interest rates imply low discount rates for discounted cash flow calculations, artificially inflating longer-dated cash flows which are typically associated with growth stocks.
2 Build-up of intangible assets. Using simple valuation metrics tends to ignore the impact of modern intangible assets like research and development (R&D) and brand value, which tend to be associated with tech or consumer discretionary names. Firms that invest heavily in R&D and brand value look expensive when price is measured against tangibles like book value or total liabilities.
3 Low inflation. While economic growth has been satisfactory, productivity growth has been poor and inflation has been depressed (or at the low end of expectations). This means that nominal interest rates have also remained low.
4 Technological shift. The period since the GFC has been dominated by a new paradigm of technological developments, most notably in communications, consumer services and the application of new technology to older problems like transport and power supply. Firms in this space have been much more successful than “old school” firms – bricks and mortar retail, transport, and entertainment have all suffered. These newer firms have often traded on excessively high valuation metrics, making older firms appear cheaper.
Coupled with low productivity and low interest rates, inflation rates have been lower during the last decade than they have for previous decades going back to WWII.2 However, with the highly stimulatory economic policies that are being implemented post-COVID, inflation expectations and long bond yields have increased.
Is this the reason for value’s return to favour? Possibly. We look at this below.
There are other potential explanations and clues to values continued outperformance. Below we show recent and longer term performance of value and growth, and how various metrics of the value style have become - and still are – quite stretched.
Long term return of value and growth
Over the last 40 years, value and growth styles have competed for dominance. In the last 10-12 years, growth has convincingly won this battle, with the five year rolling average of returns for value minus growth (for the MSCI World universe, ex Australia) below the long term average and indeed highly and increasingly negative as can be seen below.
Chart 2: Spread in Five Year Rolling Annualised Returns for MSCI World Value and Growth
Source: Realindex, Factset, data as at 31 March 2021
We might then ask the reasonable question – how much has the recent rebound in value recovered this sell down? The chart above shows that the rebound has hardly made a dent in this spread. While the uptick is gratifying and a reward to investors who continued to believe in the value style, it is early days.
Further to this, it is worth considering how much the recent rebound has affected the size of the constituent universes for growth and value, and how it has affected the valuation of cheap and expensive names. The first chart below shows the proportion of growth and value names in the MSCI World benchmark. Since 2014, growth names have more than doubled as a proportion of the benchmark weight, while value names have approximately halved.
Chart 3: Growth and Value companies as a percentage of MSCI World
Source: Realindex, Factset, MSCI. Data as at 31 March 2021
However, the recent rebound has again made little headway in returning to what we might call normal (or at least, back towards its longer term values).
The second chart shows this even more starkly, outlining the average price-to-book ratio of all stocks in the MSCI World, sorted into quintiles (by price to book). For example, the blue line shows the average price-to-book of the 20% most expensive names in the universe.
Chart 4: MSCI World Growth and Value price-to-book by quintile
Source: Realindex, Factset, MSCI. Data as at 31 March 2021.
Two things are interesting here. The first is how the spread in valuations has been caused by the expensive names becoming more expensive, not the cheaper names getting cheaper. The second is that despite the recent rebound in value, the spread is still very large and the most expensive names are still very expensive in historical terms.
All of this is a way of saying that while the recent rebound in value has been large, it has hardly scratched the surface of the trends observed over the past decade. It may be the case that value continues to rebound, and this recent period is just the start of a significant reversal of fortune for the value style. Without a crystal ball, we cannot forecast this with any certainty. However, if we take the above charts as a guide, the balance of probabilities would be in its favour.
Is the value style return associated with inflation?
There is strong evidence that inflation is picking up globally3, and real interest rates will also start to move upwards more quickly than was expected even six months ago. Bond yields have recently rebounded strongly, mostly on the back of increased inflation expectations.
Chart 5: US Government Bond Yields and Inflation Expectations
Source: Realindex, Bloomberg. Data as at 31 March 2021.
This chart shows how inflation expectations - and therefore bond yields - have turned sharply during the second half of 2020, and perhaps even earlier. (Inflation breakeven is the spread between nominal US government bonds and Treasury inflation-protected securities, and so shows the expected inflation that is priced into bonds.)
Value stocks are known to be “short duration” in nature – that is, their cash flows are near term. Growth stocks, on the other hand, are known to be long duration. In a word of low interest rates, long dated cash flows are inflated (in present value terms), which will inflate the value of growth stocks when compared to value stocks.
However, when interest rates rise, growth stocks’ valuations will decrease much more quickly than those of value stocks, for the same reason. It then follows that an increase in interest rates (through an increase in inflation) will hit long duration names relatively harder than short duration names - in other words, value will outperform. This is indeed what we have seen recently.
We have yet to see real interest rates tick up, although this is now more likely to happen sooner than was forecast last year, as the economic recovery following COVID has gained more traction than was initially expected by economists, governments and investors. Certainly, the equity markets are looking through any short term issues and continuing their upward climb.
Finally, perhaps the most interesting change we have seen in the global equity environment has been in the response of the sell-side analyst community. The first chart below plots the correlation of analyst revisions with our composite value factor since the start of 2018. Until the second half of 2020, analyst revisions were negatively correlated with value – that is, growth stocks were being upgraded, or value stocks were being downgraded, or both.
Chart 6: Analyst Revisions and Value: Correlations by Region
Source: Realindex, Factset. Data as at 31 March 2021
Since about August 2020, there has been a distinct shift in this relationship. We now see analysts shifting away from the growth-upgrade/value-downgrade cycle, to the opposite – upgrading value stocks and/or downgrading growth stocks. The analyst community is a strong predictor of future market leadership, and this shows that the shift toward value is well underway.
The next chart shows that this correlation is paired with downgrades to momentum or growth names, and upgrades to value names, both in developed and emerging markets. This shows further support for the idea of the style rotation that is well underway, and the continued leadership of value stocks when compared with momentum or growth stocks.
Chart 7: Analyst Revisions, Momentum and Value – Broad Universe Correlations
MSCI DM time series correlation between Analyst revisions and (i) Momentum, (ii) Value factors
MSCI EM time series correlation between Analyst revisions and (i) Momentum, (ii) Value
Source: Realindex, Factset. Data as at 31 March 2021
The recent rotation to value stocks has been a welcome development for investors who have retained their conviction in this investment style. Whether it is set to continue depends on a number of factors - however, the signs are good.
Firstly, there is a large scope for the reversal to continue. While the recent rebound has been large, it is framed against a universe of growth stocks with stratospheric valuations. To play catch-up, the more reasonably priced value stocks have a lot of ground to cover.
Another sign is that inflation expectations have increased. An environment of good economic growth and higher inflation bodes well for value stocks, which generally thrive in such an environment.
Finally, it appears that the ‘smart money’ is on value, with the analyst community re-rating value stocks upwards and growth stocks downward. This shift in sentiment provides another indicator that the shift towards value is well underway.
2 See, for example, https://datatopics.worldbank.org/world-development-indicators/themes/economy.html for history from the 1960s or https://www.macrotrends.net/countries/WLD/world/inflation-rate-cpi for data from 1981 to 2021
3 See for example (for Australia) https://tradingeconomics.com/australia/inflation-cpi or https://tradingeconomics.com/united-states/inflation-cpi for the USA
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