If you believe value is dead, and in the secular underperformance of value stocks, you are dead wrong. Thanks to Pfizer, the cycle has started to turn for value stocks.
There have been many stories in recent years arguing that value investing is dead. The authors of such writings substantiate their claim by providing evidence that picking cheap stocks – those with low price-to-earnings or price-to-book ratios – has been ineffective for at least the past five years. For example, the iShares Russell 1000 Value ETF (IWD)iShares Russell 1000 Value ETF grew by 14 per cent from the end of 2015 to the end of July, 2020, whereas the iShares Russell 1000 Growth ETF (IWF) iShares Russell 1000 Growth ETF soared by 143 per cent over the same period. Results are similar in Canada.
I do not agree with the “value is dead” group for at least two reasons.
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First, investors widely use the terms value stocks and growth stocks, but many do not know what they mean. Academic researchers sort stocks by P/E, P/B or other valuation metrics, and form a number of portfolios from the sorted stocks. They call the lowest P/E stocks “value stocks” and the highest P/E stocks “growth stocks." While academicians do not know which stocks from the value group value investors will eventually buy, they do know that value investors mostly choose stocks from the lowest P/E group and avoid stocks from the highest P/E group.
But value investing is more than that. Many believe that the only thing value investors do is sort stocks by P/E and invest in the lowest P/E stocks, which in fact cannot be further from the truth.
Second, the “value is dead” group confuses cyclical underperformance versus secular (that is, persistent over an indefinitely long period) underperformance of value stocks. Those who have declared the end of value investing believe in the secular underperformance story. I disagree. The underperformance of value stocks is cyclical and has nothing to do with the long run.
Let me explain. P/Es and P/Bs are a function of interest rates (and by extension of inflation). As rates have been converging toward zero over the past five years or so, the P/Es and P/Bs of all stocks have risen significantly above historical levels. In this setting, companies with very low P/Es and P/Bs tend to be bad companies and investing in them almost invariably leads to underperformance.
At the same time, P/Es and P/Bs are also a function of the growth rate of earnings. Companies have low (or high) multiples because markets expect low (or high) earnings growth. In fact, the markets tend to be overoptimistic about growth for high multiple firms and overpessimistic about growth for low multiple firms. Moreover, growth stocks' optimistic growth rate assumption interacts with current record low interest rates. Such interaction benefits growth stocks the most, as their future growth opportunities look very high in present-value terms. As a result, particularly in the interest rate environment of recent years, investors tend to overvalue (and overpay for) high multiple firms and undervalue low multiple firms. Hence, the growth stocks' higher returns.
It is also possible in the low economic growth rate environment of the past decade, investors have been willing to pay for growth firms that promise some growth as opposed to the zero growth rate projected for value stocks.
The above effects have intensified since last March, with the advent of the COVID-19 pandemic.
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However, expectations since August of an effective coronavirus vaccine, especially following last week’s announcement by Pfizer Inc. of its promising early results, have started to shift the cyclical picture in favour of value stocks. What expectations did Pfizer’s announcement change, which had not been the case in the past five years? It was expectations of faster growth (think pent up demand), higher interest rates and inflation.
The iShares Russell 1000 Value ETF has risen by 13 per cent since Aug. 1, while the iShares Russell 1000 Growth ETF has declined marginally over the same period. Since Nov. 6, IWD has jumped by 7 per cent, while IWF has declined by 0.7 per cent.
Deflation and low interest rates hit value stocks hardest and benefit growth stocks the most. The picture has meaningfully changed since Nov. 9. It has been my view for years now that underlying trends in the supply and demand of long-term investable capital call for higher interest rates and inflation than what we have experienced in recent years. The pandemic in particular has stalled these long-term underlying forces. When the pandemic ends, we will see the trends of higher inflation and higher interest rates begin to establish themselves – and this will benefit value stocks.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, University of Western Ontario.
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