– By Dilantha De Silva
Value investing strategies typically involve buying stocks of companies that are trading below their estimated intrinsic value because of unfavorable developments that are likely to be temporary. It is an attractive investment strategy for long-term-oriented investors who prefer to buy stocks at a discount and hold them until the stock price converges with the target price, and this investing technique is followed by some of the most successful investors, including Warren Buffett (Trades, Portfolio).
However, the underperformance of value strategies since the fallout of the global financial crisis in 2008 has raised concerns over the effectiveness of this strategy in an environment where the U.S. government is increasingly willing to support stock prices even more than the actual economy.
Value stocks are sensitive to economic changes, and in 2021, value has outperformed growth. The Russell 1000 Value Index, which measures the price performance of large-cap value companies, has increased close to 9% this year whereas the Russell 1000 Growth Index has appreciated just 0.13%.
Source: FTSE Russell
This positive performance is certainly encouraging news, but as illustrated above, value strategies are still playing catch-up because of their failure to keep up pace with growth stocks in the last 10 years.
A careful analysis of the global macroeconomic situation and the current valuation level of the market reveals that value is, in my view, primed for a comeback in the recovery phase of the current business cycle.
Value failed during the market rout last year
Value stocks have a reputation for performing well during market downturns. Many Wall Street analysts predicted the virus-induced recession would create a strong platform for value strategies to come back, which failed to materialize last year.
As illustrated below, growth continued to perform better even when stock markets were crashing, and this phenomenon was primarily driven by two factors. One was the stellar performance of big tech giants that benefitted from the pandemic, such as Netflix Inc. (NASDAQ:NFLX) and Amazon.com Inc. (NASDAQ:AMZN). The other was the record low interest rates and federal government support, which allowed many inefficient and poorly-run large-cap companies to survive and continue to see their share prices rise when the natural course of the market would have otherwise weeded them out.
Since September, however, value has gained some momentum as investor focus shifted to undervalued sectors of the market. Generally, value investing strategies incline toward sectors such as financial services and energy, which include cyclical stocks. The fast-growing technology sector is often ignored by value investors because of the sky-high valuation multiples at which these companies tend to trade in the market.
This sector bias was the major reason for the underperformance of value in the last few years. However, there is an ongoing shift from growth to value because of the rich valuation multiples at which many growth companies are currently trading, and an influx of institutional funds for value stocks could mark the beginning of a strong bull run.
The prospects are promising
Value companies with high operating leverage tend to perform better during the economic recovery phase of the business cycle. Arguably, I think the United States is now entering one of the strongest economic recoveries in the history of corporate America, which paints a promising picture for undervalued, high-quality companies that are likely to benefit from the revival of business activities in the country. These companies are expected to generate higher operating income once the business cycle turns in their favor.
The U.S. government has injected trillions of dollars into the financial market and the economy, which could also turn out to be a catalyst for value strategies as consumer spending will increase as a result of this growth in the money supply. Value investing involves many cyclical, consumer-facing companies that were hit hard by the economic recession. The downturn led to increased savings as consumers feared the U.S. economy could suffer for a long period of time, and this resulted in a decline in earnings for many retail companies.
The initial phase of the economic recovery will be a blessing for these companies.. Low interest rates will lead to higher business and consumer spending in the second half of 2021, which would pave the way for consumer cyclical companies to report higher earnings in comparison to the corresponding period in 2020.
Another factor to consider is bond yields. The steepening yield curve is a sign of higher inflation expectations in the future, which is good news considering the significant slowdown in business activities in the last 12 months.
The increase in money supply and higher business spending should lead to a rise in commodity prices as well, which will be a positive development for the energy sector. Crude oil remains the most widely used energy source in the world, and a revival in industrial activities will lead to higher demand for oil, thereby increasing market prices of the commodity because of the supply cuts introduced by OPEC. Even after a stellar recovery from the lows seen in March 2020, energy stocks remain the most undervalued business sector in the market from a Shiller price-earnings perspective.
In addition to being undervalued, the energy sector trades at a healthy average dividend yield of 2.73% as well. Many oil companies were forced to reduce shareholder distributions last year to improve their liquidity, but things are likely to turn around in the next six months, enabling these companies to once again distribute the bulk of their earnings to shareholders via dividends and stock buybacks. These expected dividend hikes will be additional compensation for value investors who bet on the oil sector today, despite the challenges faced by the industry.
Hedging against a possible correction
The S&P 500 continues to trade at elevated valuation multiples, which increases the likelihood of a market crash if the U.S. economy fails to gather momentum as expected. However, divesting stocks and holding cash does not seem to be the right strategy. Peter Lynch famously said:
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves.”
In the absence of a crystal ball to predict the future, the best course of action is to remain invested in stocks. Investors, however, can hedge some of the risks by investing in securities such as gold and small-cap value stocks that have proven their ability to weather downturns better than the rest of the market. In the seven different bear markets between 1926 and 2007, small-cap value has outperformed the index except during the Great Depression. The average return of this strategy was double the average return of the S&P 500 index during recessions, which makes a strong case for diversifying into this sector today with a view of generating alpha returns in the long run.
Source: Data-Based Investing
The steps taken by the federal government to accelerate the economic recovery and support share prices are reflected in the market performance of the major stock market indexes. Although growth outperformed value in the last decade, the latter has outperformed so far in 2021, and this can last a long period of time considering the positive developments for deeply undervalued sectors such as financial services and energy. Investors looking for long-term growth can balance their portfolios by using a mix of both value and growth stocks. Such diversification will play an important role in helping investors beat the market in the long run.
Disclosure: The author does not own any shares mentioned in this article.
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This article first appeared on GuruFocus.