Cheap stocks are back in the doghouse. There could be an opportunity here

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The rally in value stocks has fizzled over the past three months, demoralizing investors who prefer cheap banks, telecoms and pharmaceuticals over pricey technology superstars. But one prominent institutional investor believes that this is nothing more than a short pause.

Ben Inker, the head of asset allocation at GMO, the influential Boston-based institutional asset management firm, expects that cheap stocks will regain the momentum they enjoyed earlier this year.

“While companies and markets evolve, the valuation disconnect between value and growth has reached extreme levels today,” Mr. Inker said in a note to clients.

His renewed confidence comes as the two dominant investing styles have swung in and out of favour recently.

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Growth stocks – or high-priced stocks sought by investors looking for strong profit gains – have been the clear favourites over the past decade. Lockdowns, slashed interest rates and fears of dividend cuts underscored the advantage of growth stocks during the most horrific months of the pandemic early last year.

But value stocks, which have low valuations, embarked on a strong comeback later in the year as the economy recovered. Apple Inc. , Facebook Inc. , Tesla Inc. and loads of other growth stocks looked less enticing than, say, JPMorgan Chase & Co .

From the start of September, 2020, through May of 2021, the Russell 1000 Value Index outperformed the Russell 1000 Growth Index by a dazzling 23 percentage points, marking the best outperformance in at least a decade.

But performance has shifted, again. Since early June, value stocks have trended sideways while growth stocks have surged 14.6 per cent.

“It was frankly enough to trigger nightmares for a value manager,” Mr. Inker said in his note, referring to the underperformance in the latter part of the second quarter.

It is clear why some value investors remain committed to the style: The price-to-book ratio for the Russell 1000 Value Index is just 2.7, compared with a ratio of nearly 15 for the growth index. Some argue that this differential points to stronger long-term returns for cheaper stocks.

But the attraction goes beyond valuation.

Mr. Inker noted that it is not unusual to see growth stocks jump back in favour briefly, even when value stocks are dominating. During two particularly good periods for value stocks – 1973-77 and 2000-02, when large-cap value stocks outperformed large-cap growth stocks by 94 per cent and 114 per cent, respectively – growth stocks enjoyed some of their best months ever.

Sharp reversals, Mr. Inker said, are a common occurrence during value runs. Perhaps this is one of them.

What’s more, he argued that the current concern about an economic slowdown is not necessarily bad for value stocks. True, they performed well as North American lockdowns ended and economic growth rebounded, because of the perception that value stocks can be more cyclical.

But he doesn’t see a long-term pattern here.

“There is no broad reason to believe that value stocks require robust economic growth to do well: Both of the great value rallies of the last 50 years contained recessions (1973-75 and 2001) and neither knocked value off its stride,” he said.

Similarly, he doesn’t believe that falling bond yields are a reason to shy away from value stocks. The yield on the 10-year U.S. Treasury bond surged earlier this year as the economy recovered, coinciding with the value rally. The yield has since slumped, spurring growth.

But Mr. Inker pointed out that the correlation between bond yields and value stock performance has shifted throughout history. The positive correlation with rising yields is a relatively recent thing.

“While a continuation of that pattern would mean a slight headwind for value given falling yields and a tailwind given rising yields, it’s hard to make an argument as to why it is inevitable that rates should fall from here, or why anyone would want to structure an equity portfolio around that assumption,” he said.

His take? Value stocks trade today at a 40-per-cent discount to their historical average relationship with growth stocks, he said, meaning that cheap stocks look particularly cheap today.

“Our conclusion remains that this is the most compelling opportunity we have seen for asset allocation alpha” – or market-beating performance – “since the 1999-2000 internet bubble,” Mr. Inker said.

The big question, though, is whether growth stocks will play along.

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