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Energy and financial stocks along with smaller companies have particularly flourished in the current rotation to value stocks, duly rewarding investors that bought these areas at cheaper prices last year.

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“Buy stocks for less than they are worth and hold them as long as it takes for the market to appreciate how undervalued they are.” That’s the tenet that formed the investing approach of Sir John Templeton, the famed contrarian and successful bargain hunter.

It’s also the approach that delivered equity market winners in recent months on the back of the rollout of COVID-19 vaccines and upbeat expectations of a steady restoration in business activity this year.

That has boosted so-called value stocks – shares that are seen as undervalued on metrics such as their asset value or dividend payouts. Often more exposed to the economic cycle, they have outperformed growth stocks that often have premium valuations because of their perceived brighter prospects.

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The Russell 1000 value index for U.S. stocks has gained almost 30 per cent since November, well ahead of a 15 per cent rise in its growth sibling. Energy and financial stocks along with smaller companies have particularly flourished in this rotation, duly rewarding investors that bought these areas at cheaper prices last year.

Now comes a tough call. Have long-suffering areas of the U.S. and global equity markets pretty much priced in life returning to normal after the pandemic? Or does the rotation have the legs for a multi-year rally given the potential for a strengthening economic recovery?

The valuation divergence between growth and value stocks remains at historically wide levels.

“Value cyclicals still remain very cheap and these stocks are finally breaking out after a long period of underperformance,” says Andrew Slimmon, managing director and senior portfolio manager at Morgan Stanley Investment Management in Chicago.

He points to valuation metrics that compare prices with factors such as asset value, earnings and cash flow. For value stocks, these are still low compared with average levels stretching back to 1989.

Value investing is a broad term but basically comes down to identifying cheap companies that trade below their true worth. It can include highly indebted or distressed companies and those with challenged business models, such as retailers. Also included are mature companies, such as banks and industrials, that have cyclical revenues that mirror underlying economic activity.

Over long periods of time, stock market annals show value stocks do outperform growth. But the wait for value stocks to deliver can be an endurance test and not every investor has the capacity that Mr. Templeton had to ride out long periods when value stocks lag. One respected value investor, Ted Aronson, shut down his firm AJO Partners last year after suffering what he described as the longest drought for value stocks on record.

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Over the past decade, a business cycle of modest growth and minimal inflation hurt many value stocks and favoured paying a premium for faster-growing companies, personified by the stunning capital appreciation in tech titans. These include Facebook Inc. FB-Q, Amazon.com Inc. AMZN-Q, Apple Inc. AAPL-Q, Netflix Inc. NFLX-Q and Alphabet Inc. GOOGL-Q (the parent company of Google) – a group collectively known as the FAANG stocks.

Now economic projections are likely to be upgraded in the coming months, with last week’s passage of another US$1.9-trillion stimulus bill in the U.S. seemingly pointing to a hotter economy. That brimming macroeconomic backdrop should spur profit upgrades for companies with earnings linked to the economic cycle.

Longer term, some also think the next stage of technological transformation of the economy will boost industrials and banks.

Banks will benefit from increasing their digital presence and profitability through cloud computing and artificial intelligence. Industrial companies in machinery and equipment, aerospace and logistics also will use 5G wireless technology and robotics to transform their business models with connected machines and data.

Marco Pirondini, senior managing director, head of equities, U.S., and portfolio manager at Amundi Asset Management in Boston, adds that utilities in the U.S. “will see 10 to 20 years of meaningful investment into profitable renewable projects.”

Another tailwind may arrive from momentum-focused traders and computer-driven funds that played a big role in pushing up growth stocks to a series of record highs last year. These aim to exploit market trends but can also spur them.

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“The investment community appears underweight the non-growth elements of the equity market,” says Tobias Levkovich, chief U.S. equity strategist at Citi in New York and the equity team at Citi. They don’t rule out the arrival of non-traditional buyers chasing price momentum, but also warn that earnings shortfalls “later this year might generate a reversal away from the burgeoning value interest.”

However, Mr. Pirondini says that a three-year to four-year period of value-beating growth beckons for active managers.

“Our point for long-term investors is that there are plenty of stable companies trading at relatively low valuations that will do well in a period of strong economic growth,” he says

These are the kinds of stock-picking market conditions that Mr. Templeton harvested successfully during his long career.

© The Financial Times Limited 2021. All Rights Reserved. FT and Financial Times are trademarks of the Financial Times Ltd. Not to be redistributed, copied, or modified in any way.

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