11/18/20: News of a successful COVID-19 vaccine set off a rally in global equities as investors anticipate an end of the pandemic. Value stocks, those pandemic losers with cheap valuations and impecunious balance sheets, surged in response. The Russell 2000 Value index rallied nearly 12%, outpacing the Russell 2000 Growth index by a factor of nearly three-to-one, as the biggest impediment to holding value stocks, not knowing the length of the lockdowns. The NASDAQ 100, a market of growthy tech stocks largely insulated from the vagaries of COVID, were flat over that timeframe. The recent rotation toward value suggests that the growth-value style pendulum, at long last, could be swinging in value’s favor.
Value investing, as defined by Russell, a purveyor of equity market indices, concentrates on companies whose stock prices are low relative to their book value. The Russell 1000 Value index sports a price-to-book ratio of 2.3 times, far smaller than Growth at 11.6 times. As a result, value stocks tend to have higher dividend yields and, not surprisingly, lower earnings growth rates. Value stocks tend to be more heavily concentrated in financials, materials and energy, while growth gravitates to technology and consumer discretionary. Health care, interestingly, is evenly split.
Value investing has had a rough decade, as Growth more than doubled the return of Value, expanding by nearly 400% to value’s 180%. Famed value investor, Warren Buffet, whose Berkshire Hathaway portfolio emphasizes brand names, business moats and margins of safety, has failed to keep pace with the S&P 500 of the last 5, 10 and 15 years. Technology was a big contributor to Growth, expanding more than six-fold since 2010. Meanwhile, energy shares weighed on the value index by declining 20% over the last decade. Valuation expansion accounted for most of the performance difference between growth and value. From 2009 through 2019, PE expansion accounted for 200 percentage points of Russell 1000 Growth’s 300% total return, while PE expansion contributed 70 percentage points to the Russell 1000 Value’s 200% return over the same period. Stripping away valuation expansion, Russell 1000 Value’s earnings and dividend return totaled 136% between 2009 and 2019, outpacing Russell 1000 Growth’s 112% earnings and dividend return of the same timeframe.
The Federal Reserve’s increasingly accommodative monetary policy has been the primary driver of the equity market’s valuation expansion, particularly among growth stocks. Over the last decade the benchmark 10-year Treasury yield slid from 4% to less than 1%, while the Fed’s balance sheet mushroomed to over $7 trillion from $2.2 trillion, pushing the S&P 500 price-earnings ratio to 26 from 15. As a result, low interest rates and a record Fed balance sheet have driven equity markets to historically high valuations.
Federal Reserve governors insist our country’s monetary authority has plenty of dry powder to address any impending economic challenge, although Fed Chairman Jay Powell asserted that he has no plans to push overnight rates into negative territory. Maintaining overnight rates below the inflation rate for an extended period could push rates higher, due to stronger economic growth or rising inflation pressure. Anything that causes interest rates to rise could eliminate, or potentially reverse, equity market valuation expansion. Rising long-term government bond yields and stronger economic growth would weaken the appeal of growth companies which have enjoyed a valuation premium for years.
Stripping away valuation expansion would force equity investors to rely on organic accumulation of dividends and earnings, two attributes favoring value investing. Between 2009 and 2019, the Russell 1000 value index derived 136 percentage points of return from dividends and earnings exclusively, while dividends and earnings accounted for only 112 percentage points of the Russell 1000 Growth’s return. Relative to Value, Growth’s earnings multiple is trading near its 20-year high. Since value investors buy earnings at a cheaper multiple, the return potential derived from earnings is higher, even though its growth rate is lower.
Investing in value in this environment requires individual security selection, not simply screening for stocks with bargain basement price-earnings or price-to-book ratios. Many cheap stocks are cheap for a reason. That’s why balance sheet quality is paramount. Generously low interest rates have kept insolvent companies alive. Zombie companies may appear cheap by some measures, but value investors shouldn’t be distracted by the walking dead. Screening for valuation without regard for quality would be like a moth not determining whether the light source they’re attracted to is a flame. Nearly one-third of the Russell 2000 index of small capitalization stocks, for example, have not produced a profit in more than five years.
Pricing power is another consideration. The ability to set prices or raise them if necessary, is critical in maintaining a healthy profit margin in all environments. Larger companies tend to possess a higher degree of pricing power than their small cap counterparts. Mega-cap companies not only enjoy a higher profit margin than their smaller competitors, but they have been able to hold the line on profit margin erosion during the pandemic.
It’s been a rough dozen years for value investors, but the tide may be turning in their favor. Relatively cheaper valuations should enable this beleaguered group opportunity to catch up. Investors must be picky, however. Value investors must demand their companies possess strong balance sheets and enjoy pricing power to lead the way over next market cycle. Talk to your Cresset advisor to take advantage of the shifting trends.