Why Value Stocks are Positioned to Win in Today's Economy

Growth stocks outperformed value during the 90s, through the dot com boom, and over the last decade.

In fact, growth has outperformed by so much, for so long, that many have taken it for granted that these stocks and funds will always outperform.

However, the value factor, as defined by Fama-French, has in fact outperformed growth on average over ten-year time horizons dating back to 1936. Put another way, since 1927, value stocks have outperformed growth by 4.1% annually in the US.

Therefore, the potential future outperformance of value would be a reversion to the mean rather than a change to the status quo. It seems growth has always been the leader but in truth, the dominance of growth is something of an exception.

Given that growth stocks have been the focus of so many investors, some may have forgotten the core definition of a value stock. These are equities characterized by having an intrinsic value that is higher than their current trading price. These are often older companies with strong current free cash flows.

Here we look at why the current setting could position value stocks to outperform growth stocks for some time.

Source: Dimensional

Why Value Underperformed in Recent History

Research shows that three factors created the environment in which value underperformed growth over roughly the last ten years:

Real Interest Rates

Until recently, we have been in a low interest rate environment. While both growth and value benefit from a lower discount rate, growth benefits more. Why? Because the cost of capital is lower and because base-level growth is greater given that cash flows are weighted further in the future for growth stocks. In contrast, value stocks would have a lower valuation upside compared to growth since cash flows are weighted more to the present.

Corporate Profit Growth Rates

While corporate profits have grown over the last decade they have not grown by as much as we are seeing today. When there is less relative growth investors are more willing to pay a premium for it as they have in recent years. This setting is changing. By the end of the third quarter last year corporate profits reached a record high of $2.08 trillion. In fact, quarterly profits have soared by over 80% over the last two years. Investors are now less willing to pay a premium for growth because it is more abundant.

Equity Market Volatility

When equity market volatility is relatively low investors largely feel more optimistic. As a result, they are willing to choose growth stocks because they have the potential for downstream price appreciation. However, today uncertainty is on the rise. Looming Fed decisions, inflation, the war in Ukraine, fears of a recession, and geopolitical tensions have made investors anxious about the future. In this environment, investors usually want the more immediate cash flows associated with value.

Why Value is Poised to Overperform

Now is the time for investors to reevaluate the weighting of value stocks in their portfolio. An analysis from Vanguard concludes that “value should outperform growth by between 9% and 13% over the next five years and 5% to 7% over the next ten years.” There are three reasons for this forecast:

Inflation:

Inflation could persist as demographic decline takes hold, reducing available goods as more people exit the workforce globally. This means there will be fewer workers to generate the goods and services that are still needed by the entire population. The result: too much money chasing too few goods. Higher inflation could help value stocks because Inflation is factored into the discount rate used to value equities and a higher discount rate increases the value of cash flows that are more near term which is common to value stocks.

Interest Rates:

Rates are likely to stay higher longer as inflation remains sticky. Consider remarks from, New York Fed President, John Williams who explained that “we need to retain a sufficiently restrictive stance of policy. We’re going to need to maintain that for a few years to make sure we get inflation to 2 per cent.” Higher interest rates increase the discount rate which boosts the valuation of value stocks relative to growth.  

Volatility:

Deglobalization, agriculture problems due to fertilizer shortages, the ongoing war, and global warming will continue to contribute to volatility which often prompts investors to move to the relative safety of value stocks with strong current free cash flows.

Why Investors Should Consider Adjusting Their Allocations

Many investors have drifted towards an overweighting of growth stocks and funds given that “around the world, the proportion of equity assets invested with Value managers has fallen to 5%-10%,” according to JP Morgan.

The time to start revisiting value allocations is now because “value has outperformed growth by more than 20% since the Pfizer vaccine announcement on 9 November 2020.”

Fortunately, we are likely still at the beginning of this trend which gives investors an opportunity to position themselves for a long-term setting that could very well put value equities in the lead.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc. or Trackinsight. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.