Value investors just can’t catch a break. Their latest blow was this week’s change of heart by the U.S. Federal Reserve.
The Fed’s sudden and surprising conversion to dovishness adds to a decade of disappointment for dedicated value hunters. Their strategy emphasizes buying shares that are cheap in comparison with underlying fundamentals such as sales and earnings. In theory, it is an eminently sensible approach to picking stocks. In practice, it has flopped since the financial crisis. For years now, value stocks have lagged behind the broad market.
Many observers, though, had expected a value-stock rebound this year. They argued that the Fed’s apparent commitment to hiking interest rates would make value stocks more attractive. These shares offer a margin of safety for investors, and that margin of safety should become more and more important as financial stresses mount.
The problem with this scenario is that interest rates no longer seem destined to rise. The Fed went to great lengths this week to signal a change of direction and tamp down expectations for future rate hikes. In fact, a growing number of people now expect it to start cutting rates at some point next year. Since the Fed is the world’s most powerful central bank, this is bad news for value stocks, globally as well as in the United States.
The biggest beneficiaries of the Fed’s change of heart have been growth stocks – expensive but fast-growing companies, often in the tech sector. They jumped after the Fed’s announcement on the theory that if rates are going to stay low or move even lower, then economic growth must be slowing. Investors in search of strong returns have little alternative but to wait around for the profits that might eventually materialize from the likes of Netflix Inc. and Amazon.com Inc.
So should value investors throw in the towel? To find out, I spoke to Jeff Weniger, director of asset allocation at WisdomTree Investments Inc., a New York-based provider of exchange-traded funds. While recognizing the current challenges, he still manages to sound cautiously optimistic about the outlook for value investing.
He argues that value’s current slump is nearing historic proportions. By his calculations, the degree by which value stocks have lagged their growth counterparts in recent years is second only to their underperformance during the dot-com bubble of the late 1990s.
Back then, the sizzling performance of growth stocks ended abruptly, giving rise to a seven-year period in which value investing surged back into fashion and outpaced growth. It is possible we are on the verge of a similar transition.
What is required to change investors’ minds is something that would shake faith in high-flying tech stocks. In Mr. Weniger’s eyes, the most likely catalyst is politics.
He argues that leaders across the political spectrum are now looking for ways to rein in companies such as Facebook Inc., Amazon and Alphabet Inc. At the very least, the tech giants are likely to face tighter regulation – as demonstrated this week by the European Union’s decision to fine Google $2.3-billion for anti-trust violations.
If lawmakers do hobble the tech stars, investors may start paying less attention to revenue growth and more attention to the prosaic matter of how fast companies are expanding their dividends. Contrary to what you might expect, value stocks have shone in this regard, boosting their dividends at a faster rate than growth stocks in recent years. On that score, “there has not been much growth in growth,” Mr. Weniger says.
He is clear-eyed about the fact that any transition away from growth stocks and toward value stocks could take a long while. Despite what many people think, value stocks do not always outperform in a bear market, he says. And some of today’s cheapest sectors are riskier than they might appear.
Take energy stocks. They are cheap on many counts, which makes them attractive to value hunters. On the other hand, they face an uncertain future, as concerns grow over the threat from climate change.
Still, it would not take a big change in mentality to spark a shift in market leaders. As it now stands, the tech sector makes up roughly a fifth of the S&P 500, an unusually high level, and one that would be even higher if not for a recent reshuffling of the benchmark index, which put many social-media stocks into a different category.
In contrast, resource stocks make up far less of the index than is typical. The consumer staples sector is also smaller than is usual as a portion of the overall index. Investors in search of underappreciated, overlooked stocks may want to start their search for bargain in these areas.