May 15, 2021 | Institutional Perspectives | 7 min read
Value is Back
In the eye of the storm in June 2020, we published a piece on value investing. Titled “Has Value Had Its Last Dance?”, the article asked if value’s best days were behind it. Like the storied Chicago Bulls in Michael Jordan’s final year, were the good times gone? Was value dead?
It’s pretty typical when assessing investment performance for concern to really elevate just as a cycle is about to turn. Growth had a strong advantage in the 2016 to 2020 period, but it was bound to end at some point. In our reports to clients during 2020, we identified the obvious catalyst as the approval of vaccines. We forecast that confidence would then return, the economy would recover from the COVID lockdowns, and a “game on” mentality for overlooked and undervalued stocks in sectors like financials, industrials and consumer stocks would take hold areas we called essential components of a functioning economy.
It’s during periods of value under-performance that we need to work especially hard to communicate to clients the fundamental basis and persistent, proven merit of value investing. We deliberately avoided calling it a period of concern, as we have been there before and emerged intact and strong on the other side. This time we responded as we always have done by focusing on the 3 Ps of People, Philosophy, and Process.
People is an easy one for us to get comfortable with, as our teams have low turnover and have been through these cycles before.
Philosophy is an even easier box to check, as our value style survives cycles of
retirements and new hires and is the glue that holds everything together.
Process was where we focused most of our attention in 2020, making sure that every move in the portfolio was consistent with our value style.
The key was sticking to what we know and do well. Revisit all positions in the portfolio. Exit those that may be losers. Deploy into out-of-favour sectors to capture the rebound as much as possible. These trades are not meant to feel comfortable in the middle of a market crash (and they are not). Comfort would be buying the market winners – getting exposure to expensive FA ANG stocks, especially the stay at home winners like Amazon and Netflix. Comfort would also mean capitulation. We bought more consumer stocks, more banks and selectively increased our natural resources exposure.
These moves added materially to our outperformance since the market lows of March 2020 and so far, the rebound has met our expectations:
Figure 1: Performance of Leith Wheeler Equity Funds vs Benchmarks, 1 Year Ended March 31, 2021
As Figure 2 illustrates, growth and value stocks generated broadly comparable returns from 2010 – 2016, but then growth took off – delivering annualized returns nearly 15% per year above those of value stocks for over four years.
Figure 2: Annualized Performance of Growth and Value Styles, March 31, 2016 – August 31, 2020
Figure 3 shows the turn in performance in September 2020, with value stocks outperforming growth nearly 7:1 over the subsequent seven months. It’s only seven months, but it’s a solid start.
Figure 3: Performance of Growth and Value Styles, Seven Months Ended March 31, 2021
Are We Now in the Beginnings of a Sustained Run for Value?
John Kenneth Galbraith is famed for saying “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” We have to approach the question of whether value will go on a sustained run with humility, but we feel very good about the prospects for our portfolio relative to the broad markets. We have seen value go on many sustained runs in the past, and we are cautiously optimistic that we may be entering such a period again.
There are several fundamental reasons why we feel confident. While our stocks are up materially since the bottom in March 2020, our portfolios still have a significant advantage. For one, growth stocks are still trading at much higher multiples than normal. Figure 4 shows the ratio of forward price/earnings (P/E) ratios for growth versus value stocks since 2016. Being above 1.0 indicates growth has traded at higher multiples than value, and the march up and to the right shows the increasing valuations accorded to growth stocks over time, relative to value.
As of the end of 2020, growth stocks were still 74% more expensive than value stocks near recent highs. But they have risen primarily due to an expansion of their P/Es as people have agreed to pay ever-higher prices for future, not-yet-delivered growth. This advantage is not sustainable and was bound to crack at some point.
Figure 4: Price/Earnings Ratio of Russell 1000 Growth Index Relative to Russell 1000 Value Index, June 2016 – Mar 2021
We see greater-than-normal valuation discounts in our portfolio as a result, compared to broad market averages. This valuation discount should be a powerful tailwind as the economy continues to recover and our portfolios can re-rate higher, adding to return.
Many companies in our portfolio focused on paring back their cost structures through operational efficiencies during the pandemic. They should emerge leaner, stronger, and better able to take market share from weaker competitors. We are already seeing several examples of positive earnings surprises in our portfolios.
All of this bodes well for multiple expansion in our portfolios. Bond yields have risen off their lows this year, possibly reflecting concern about rising inflation and/or optimism about economic growth. Rising yields may not be an impediment to equity markets if they coincide with improved economic conditions. In Figure 5 below, we show eight periods of rising rates in the US since 1993. The S&P 500 Index rose an average of 17.7% per year during those eras, when 10-year yields rose an average of 1.7%. In such an environment, the prospects for value stocks appear better to us as well. Higher yields are generally good for financial stocks, which have a higher weight in value indices. Growth stocks are valued primarily on cash flows further out in the future and are sensitive to the growth rate of those cash flows. All other things being equal, applying higher discount rates to those longer duration cash flows will negatively affect their prices more than it will for value stocks. This bodes poorly for the highest multiple growth stocks, where we are under-represented right now, but may give us an opportunity to buy some of these businesses as we move forward.
Figure 5: S&P 500 Performance During Periods of Rising Interest Rates, October 1993 – March 2021
The immense popularity of the Netflix Chicago Bulls series has reignited a new following of Michael Jordan. One cannot get Nike Air Jordan shoes when they are released by the stores by simply walking in. In a phenomenon I was not aware of until my son explained it, one has to enter a store lottery before release day. This is unlikely to work, so kids are buying Air Jordans online in an aftersales market from other kids or pros – shoe scalpers – who access online buying using sophisticated tools. It’s not good value, at about 40% or more above retail, but my son tells me there may be a greater fool to re-sell them to, possibly for more? These shoes sound a lot like some of the overpriced stocks in the market, fueled by retail investors looking to make a quick profit before exiting.
Jordan and his team had that last amazing season, but that was not his last dance. Even today, kids who never saw him in his pomp, want Air Jordans. His brand endures beyond that decade or two when he was playing and we believe the same durability is true of our style of investing. Owning quality businesses at cheaper prices, with reasonable assumptions about their growth, should trump owning ones that are expensive with too much optimism baked in. This fundamental concept has worked for us since 1982 and this time, or next time, isn’t different.
IMPORTANT NOTE: This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of writing, but is subject to change without notice. Forward looking statements are based on our assumptions, results could differ materially.
Reg. T.M., M.K. Leith Wheeler Investment Counsel Ltd.
M.D., M.K. Leith Wheeler Investment Counsel Ltd.
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