Value beats growth. That’s arguably the theme that, more than any other, has proved the long-term winner in equity investing. Picking the cheap and unloved over high-fliers is the strategy advocated by the most influential students of markets: Think Graham and Dodd, and a pantheon of money managers from Warren Buffett to Daniel Loeb. And it’s worked brilliantly over the long haul: A family that for the past six decades bought nothing but value stocks is now four times richer than the clan that bet exclusively on growth.
But in recent years, the traditional loser has been famously thrashing the longstanding champ. Value has been experiencing a drought so deep and extended that many on Wall Street believe we’ve entered a new paradigm. Tech superstars have been far outperforming inexpensive names in such sectors as banking and manufacturing for years. And the Great Lockdown prompted by COVID-19 has lengthened growth’s lead over value to an all-time record. The likes of Apple and Amazon are thriving as consumers buy digital gadgets for working at home and flock to online shopping, while value stalwarts in such sectors as airlines, retail, and hotels have taken their worst beating in decades.
Fans of the sprinters believe they’ll keep lapping the field. The view gaining momentum: Even as the tech players mushroom into giants, they can keep growing incredibly fast, because they harbor such rich options for branching into groundbreaking fields and products.
It’s hardly surprising that growth has gained cachet as the better place to be. Over the past 13 years, the glamour category has been handily beating unlovely value, the longest period in history for which what’s supposed to be the market’s bargain basement has lagged. But despite the long losing streak, the widespread talk of value’s demise is misguided and especially wrongheaded at this moment in the markets.
“The conditions have never been more right for value to far outperform growth as the economy recovers over the next few years,” says Vitali Kalesnik, a Ph.D. economist from the University of California, Los Angeles, who serves as director of research for Europe at Research Affiliates, a firm that designs investment strategies for $148 billion in mutual funds and ETFs.
The reason value looks so promising just as its record versus growth is hitting all-time lows is basic. Historically, the cheaper value becomes in relation to growth and hence the overall market, the more it outperforms going forward. The bigger the gulf between the two, the stronger the springboard for value.
In the COVID-19 economy, that gap has never been wider. But it’s just one of three drivers that are now joining forces. The second: Value traditionally wins big coming out of deep recessions, and the U.S. is living through the worst downturn since the Great Depression.
Here’s the third factor: Value wins biggest when a reeling economy explodes a stock market bubble. That giant pop could be looming. Led by what we’ll call the FANMAGs (Facebook, Apple, Netflix, Microsoft, Amazon, and Google parent Alphabet), growth stocks are now at their most exuberantly priced since the tech craze’s summit in 2000.
Lessons from downturns past
How value’s steep descent and growth’s ongoing explosion portend a stunning reversal of fortunes is the subject of an excellent new article, “Value in Recessions and Recoveries,” by Kalesnik and coauthor Ari Polychronopoulos. They examined the performance of value compared to the overall market during six previous downturns and the rebounds that followed. I talked with Kalesnik to learn what history is likely to tell us about the road back from the COVID-19 cataclysm.
The authors note that one of two forces, or in rare cases both, drove all six recessions they studied: a shock to fundamentals, or the collapse of a bubble in stocks. In four episodes, the cause was a basic economic tremor: the fiscal tightening during the Vietnam War from 1968 to 1970; the Iran oil crisis of 1980 to 1982; the Fed-engineered interest rate increases in mid-to-late 1990; and the global financial crisis from late 2007 to early 2009. The tech crash of 2000 was the only instance when a crash in stocks was the principal dynamic. Only in one case did an economic tremor coincide with market meltdown, when the OPEC oil crisis of 1972 to 1974 caused a sharp pullback in the “Nifty Fifty” stocks, including IBM, Polaroid, and Revlon, the FANMAGs of their day.
For each period, the authors establish a “value” bucket consisting of the 30% of S&P 500 stocks with the lowest price-to-book-value ratios, meaning that their market caps are the most depressed compared to their net worth, the excess of their assets over their liabilities. For companies to fall in this lowest tier means that investors are pessimistic about their future sales growth and profitability. The low-price-to-book crowd are the market’s dogs. They’re the opposite of the shooting stars that are awarded huge valuations compared to their net worth or earnings, meaning investors are counting on epic performance in the years ahead that far exceeds today’s sales and profits.
Although only one recession saw the bona fide busting of a frenzy, all six included bear markets. In general, value stocks fell less than the overall S&P 500 during the big selloffs. On average, the lowest price-to-book contingent fell 23.8%, while the entire 500 dropped over eight percentage points more, by 32.2%.
Where value really shines is in recoveries. Over the average two-year period following the market bottom, value jumped 85.6%, trouncing the S&P’s rise of 61.4%. Value also beats the averages over the entire span of from the start of the down market to a full economic recovery. Value notched a full-cycle return of 38.5%, beating the 500 as a whole by more than five to one.
Given today’s conditions, it’s especially important to study what happened when the S&P 500 started the cycle radically overpriced. On those two previous occasions, value beat the index by the biggest margin. It outperformed by 47% during the OPEC crisis that included the Nifty Fifty’s fall from the heights, and in the tech bubble of 2000—the pure-play case of collapsing stocks pounding the economy—value gained 62.2% from the start of the bear market in 2000 to the time the economy staged a full comeback in the fall of 2004. Over that period, the S&P dropped by 20.3%, meaning that the players that started out with the cheapest stocks bested the field by a stupendous 82.5%.
“We’re getting into a bubble period”
Kalesnik warns that today’s scenario is reminiscent of the heady days before the tech disaster that struck two decades ago. He also cautions against buying into the kinds of “this time it’s different” theories that crashed with the dotcoms. He points out that what has propelled most of the market’s gigantic rise over the past few years is a narrow group of tech darlings encompassing the FANMAGs as well as other fast-growing names such as Tesla and PayPal. Those big six FANMAGs have seen their valuations rocket from $526 billion and 4% of the S&P 500 total valuation at the start of 2007, to $7.1 trillion and 24% today. In the absence of their huge contribution, the market’s overall return since then would be 30% lower.
“We’re getting into a bubble period,” says Kalesnik. “You have one-fourth of the total market cap in a few companies that overall have extremely high multiples of price to earnings and book value. They’re priced on the hopes they can grow at the same rate as giants as they did as tiny companies infinitely in the future.” He brands that much concentration in extremely expensive stocks as “dangerous.”
Hence, those richly priced FANMAGs, along with other rockets such as Tesla, are highly vulnerable to a steep fall. That prospect raises the odds that value will outperform growth by an even bigger margin than in most recoveries. Value should also benefit from the tightening of that yawning, steepest-ever discount to growth.
Over the past 57 years, the price-to-book for growth stocks has averaged 4.7 times that for value. By the end of January, in a raging bull market, that difference had jumped to nine to one. Then came the big selloff that sank the S&P by around 35% in March. Remarkably, value got hit even harder than growth, in part because tech stocks held up. And for good reason: Online sales and tech equipment and services, for everything from video games to virtual meetings, are prospering in the Great Lockdown. As a result, by the end of March, the growth-to-value price-book ratio hit 10.3. Then the market rebounded, and once again, growth beat value. Such industries as energy, airlines, and financials have recovered a bit but remain far below their levels of early this year, while all six of the FANMAGs hit all-time highs during the S&P’s resurgence to record levels.
So value is dirt cheap compared to growth. But is it really a deal, or just what looks like a buy when stacked against a cohort dominated by bubbling tech? “Essentially, growth is at one of its most expensive levels in history while value is at one of its cheapest levels in history,” says Kalesnik. Right now, value’s price-to-book ratio stands at around .58. That’s about 70% of its average over the past 60 years. As recently as 2014 and 2017, it was twice this expensive.
This measure is especially meaningful. Just when value looks like it has nothing going, it’s not just the best buy in an overheated big-cap market—it’s a good buy, period. Fear is what breeds terrific bargains and big gains, and fear is pounding value stocks. “Companies in areas like energy, financials, and airlines will recover,” says Kalesnik. “Of course, in each sector, you could have bankruptcies. But overall, they’re key sectors of the economy, and their sales and profits will bounce back.”
On the other hand, today’s superstars will attract hungry competitors, are already drawing lots of political scrutiny, and will retreat when investors realize they can never meet Wall Street’s bluebird forecasts and investors’ inflated expectations. Meanwhile, the world is expecting even less, far less, from value than usual. Chances are, the downtrodden will more than meet those paltry expectations. As value shows it can clear that super-low bar, value stocks will deliver strong gains, just as in past recoveries. The best bet is that we’re going back to the future, and value will repeat as champ. And win big.