Value stocks are poised to return to favour late next year, according to the Bank Credit Analyst.
The Montreal-based macro-forecasting and research firm argues in a special report that higher interest rates will bring badly needed relief to bargain-hunting investors after more than a decade of misery.
For value investors, any light on the horizon would be welcome news. Standard value strategies have produced mediocre to abysmal results over the past 11 years, while growth stocks, particularly in the technology sector, have soared. At least some people now question whether value strategies are dead.
The obituaries are premature, according to Mark McClellan and Doug Peta of the BCA. Growth’s winning streak over value is now the longest in market history, but they think the value approach will bounce back as interest rates climb.
“Growth stocks are as expensive as they have ever been, outside of the tech bubble era in the late 1990s,” they write. They foresee a period in which returns will revert to the mean, with growth strategies lagging and value strategies making up much of the ground they have lost.
Value investors have, of course, been hearing similar predictions for years. What has been missing for a value revival, according to the BCA team, is tight monetary policy. A sustained rise in interest rates to punishing levels is the necessary trigger for a value comeback, they argue.
Why are interest rates so important? Value strategies typically focus on companies selling for low multiples of their earnings, book value and other fundamental measurements. These companies provide a margin of safety when times turn tougher. But when interest rates are extremely low, as they have been ever since the financial crisis, earnings and multiples surge for all companies. There’s no particular reason to prefer value companies over their fast-growing, highly priced counterparts.
The situation changes when interest rates climb and monetary policy turns tighter. “It is only when policy is tight, and the tide is going out, that the margin of safety offered by the lower-priced stocks yields the greatest benefit,” the BCA analysts say.
They argue that much of the conventional wisdom around value investing is wrong. Despite what many people think, value strategies are not lagging because inflation is low or because the economic expansion is in its latter stages. The key factor is monetary policy – whether the U.S. Federal Reserve is raising interest rates and how the current level of rates compares to the equilibrium rate, defined as the level that neither encourages nor discourages economic activity.
As a general rule, investors should seek out value stocks when monetary policy is tight but invest more broadly when policy is easy. Right now, according to the BCA analysts, monetary policy remains in the early phases of the policy rate cycle and is still relatively easy. It will likely remain so until some time in the second half of 2019, at which time the Fed is likely to have to take a hard line with rate hikes. At that point, value should wake from its long coma and start to outperform.
Investors who want to take full advantage of that recovery should select stocks using a variety of yardsticks rather than simply trusting ready-made value indexes, according to the BCA team. Standard value indexes are typically compiled using trailing multiples, which measure results over the past year, rather than looking forward. They also rely on reported earnings, which “are an imperfect proxy for cash flow.”
A better approach, according to BCA, is to filter for value using both trailing and forward price-to-earnings ratios, as well as measures such as price-to-tangible book, price-to-sales and price-to-cash flow. The analysts recommend applying this approach within sectors, looking for relative cheapness within many industries.
“The long slump [in value strategies] has led some investors to argue that value investing is finished, killed by a combination of overexposure and short-term performance incentives,” the BCA team says. “Other investors see value’s long drought as an anomaly, and are looking for an opportune time to bet on a revival. We are in the latter camp.”