For investors who are just starting out, anything that is not a high-growth, supercharged, change-the-world tech stock can be a hard sell. TSLA is the future, so why in the world would old-school consumer staples stocks or energy plays be of interest?
Such market sages as Warren Buffett and his mentor, Benjamin Graham, prospered mightily by betting that cheap, unloved “value” stocks will beat the pricey, glamorous “growth” players over time. And it might surprise you to learn that academic studies confirm that during long periods, value indeed outperforms by a wide margin. But the experience of the past quarter-century––and especially the fabulous performance of the tech titans throughout the pandemic––appear to turn the conviction that the generally dull plodders offer the best buys on its head. In recent years, the champs haven’t been the automakers, energy names, and retail stores earning the most cents for each dollar you’re paying for their shares, but the Googles and Amazons and Nvidias and Teslas that already looked super-pricey pre-COVID, yet since mined the pandemic to deliver some of the best short-term returns in the annals of equity markets.
We’re about to witness the revenge of the dogs, argues a new paper from Research Affiliates. The firm fashions investment strategies for over $171 billion in mutual funds and ETFs, and employs many of the best minds in finance. The authors of the study Did I Miss the Value Turn? are RA founder and former editor of Financial Analysts Journal Rob Arnott; RA partner and an economics Ph.D. from UCLA Vitali Kalesnik; and Lillian Wu, VP of research at RA with a master’s in financial engineering, also from UCLA. This brain trust crunched decades of data showing that because growth has been thumping value for so long, value’s now cheaper by its biggest margin since the peak of the tech bubble two decades ago. Investors showing the guts to embrace the likes of oil and gas, and heavy manufacturing today should pocket returns a decade hence of 5% to 10% adjusted for inflation. The study predicts that European and Japanese value stocks will garner twice the gains of the overall equity markets in those countries, while folks and funds that buy U.S. value will way outrun a broad market that will barely keep even with inflation.
Growth has enjoyed a long winning streak
The growth stock category is defined as the 50% of all names that feature a ratio of market cap to a fundamental measure (such as earnings or book value) that’s higher than average. The value tier comprises the half whose ratios fall below the median. For this story, we’ll use the price-to-book measure, the principal metric that Arnott et al. deploy. A high price-to-book means that investors are paying a rich price versus all the dollars in capital the company has deployed to make a product or provide a service. It suggests that investors are banking on strong future earnings growth to justify the rich valuation and deliver strong returns. A modest price-to-book shows that the automaker or store chain is so inexpensive that it can reward shareholders by generating only slow, grinding gains in profits. Growth is the domain of great expectations, while value is the land where just achieving mediocrity can beat the overall market.
Today, the dominant growth stocks are the giants of software, social media, fintech, and smartphones and other IT devices. The top value category is energy, encompassing producers, pipeline operators, and equipment suppliers. Retailers and auto- and auto-parts makers are also traditional value plays that look cheap today, while such choices as cruise lines, hotels, and airlines got pushed deeply into the bin by the pandemic. The value group tends to be “cyclical,” meaning they suffer more than growth in a recession, but rebound faster in a recovery.
The authors trace how the remarkably long dominance of growth, greatly enhanced by the pandemic, has made the category so expensive relative to value that the laggard is poised to take charge. After selling at a record discount to growth at the height of the tech bubble in 2000, value rebounded sharply until the calm preceding the Global Financial Crisis in late 2006. From there until the onset of the COVID-19 outbreak in March of 2020, value underperformed growth by 17%. The pandemic hugely widened the gap. By August of last year, value was trailing by an astounding 34% over the full 14-year span.
The pandemic played to the advantages of Big Tech, while pummeling the cyclicals that always suffer big-time in a steep downturn. Amazon thrived delivering goods ordered online to the doorstep of stay-at-home America, while Apple and Microsoft prospered selling IT gear for working from your den, and PayPal feasted on the boom in virtual shopping. By contrast, the lockdown pummeled sales of industrial equipment, energy products, and hospitality, hammering value stocks.
Last summer, it looked as though the pandemic was waning, and the world appeared to be getting back to normal. Value, whose fortunes are heavily dependent on economic fundamentals, staged an impressive comeback. From September of 2020 to early June of 2021, it outpaced its rival by 8%. But in the late spring and early summer, the more-contagious Delta variant struck. “The Delta variant precipitated fears of more lockdowns and potentially more virulent future variants,” the report states. “As a result, tech stocks were reinvigorated, and over half the value stocks’ gains were wiped out.” The authors predict that when a recovery takes hold, the old economy stalwarts will do far better than today’s shooting stars. That’s because recoveries always benefit cyclicals most. Hordes of Americans will return to stores and restaurants, board planes for vacation destinations, and refill their gas tanks to get back on the road. At the same time, the virtual shopping boom, a new mode of purchase that created a potent tailwind for tech, will abate.
The future belongs to value
Value’s new pullback makes the category the best deal versus growth at any time in recent history. The authors reckon that value has only been this cheap alongside the glamour class once, at the peak of the tech bubble in 2000. They predict that the recovery will soon get back on track as more of the world’s population is vaccinated, and as fears of another virus-induced recession that would drive value names into bankruptcy wane. Traditionally, value has proved a superstar during economic revivals like the one now gaining pace across the globe. The authors studied how the two classes performed in the six most recent recoveries. They found that in the two years following the date the rebound began, value outpaces growth by an average of 23%.
Sure, value’s selling at a big markdown to growth. But does that make it a good deal? As it turns out, the gap between growth and value is so huge that the latter is priced right for just about the best future returns of any category of stocks and bonds, the authors conclude. “When most liquid asset classes are set to deliver a negative or near-zero real return, value stocks are the only asset likely to generate 5% to 10% real returns over the next decade,” they write. The paper predicts that Japanese and EU stocks overall will generate inflation-adjusted returns in the paltry 3%-a-year range over that horizon, while a value portfolio will garner 7% gains in Japan and 8% in Europe.
The biggest gains in any class, they predict, will flow from a portfolio of emerging-market value stocks. The study forecasts that the category offers such low prices versus book value and earnings that it will deliver real returns of almost 10% a year. That’s the only place where the study predicts that inflation-adjusted returns will reach double-digits. The authors warn, however, that those markets also pose the biggest risks, demand the most patience, and take investors on the most lurching journey.
In the U.S., they posit that value will be good for real returns of around 4.5%. That’s hardly stupendous. But in their view, it’s far better than what investors can expect from the broad market. They forecast that U.S. stocks overall will decline around 2% a year in real terms over the next 10 years, meaning they will simply track inflation. So value should do a full six points better than equities overall. The study suggests that the worst choice is bulking up on growth, the advice often dispensed on Wall Street. Buying what’s cheapest hasn’t worked for years. But for the RA folks, some of the world’s smartest market watchers, the downtrodden’s time has come.
4 value funds to buy now
An excellent choice is the T. Rowe Price Value Fund (TRVLX), comprising big-cap U.S. stocks and featuring a five-year return of 13.4%. The fund tilts heavily to financials and health care. Among its largest holdings are Morgan Stanley and Wells Fargo, along with a raft of cheap-looking industrials such as GE and Danaher. Expenses are a relatively modest 78 basis points.
The cheapest of cheap value lies in emerging markets. A great pick is the Pimco RAFI Dynamic Multi-Factor Emerging Markets Equity ETF (RADMFENT). The fund uses a strategy called fundamental indexing that purchases stock across emerging economies based on their size in the economy rather than their market cap. That gives the likes of big industrials and energy players with low valuations a heavy weight. Among the top holdings: Gazprom and Lukoil of Russia and automakers Hyundai and Kia of South Korea.
The Vanguard Value ETF (VTV) is extremely low cost at four basis points. It’s returned just 9% over the past three years, but should outperform going forward because value is so underpriced versus growth. It’s heavily invested in industrials, health care, and financials. Top holdings include relatively low multiple and strong dividend names such as JPMorgan, Procter & Gamble, and Pfizer.
The Dimensional Fund Advisors U.S. Large Cap Value (DFLVX) at a fee of 0.29% is in all the right places: health care, industrials, and energy, and also holds a bunch of undervalued tech stocks, including Intel and Thermo Fisher Scientific.