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Are Value Stocks Ready to Grow Again?

By Reshma Kapadia

      Photo: Peter Crowther 

Quick: Name a famous investor. Whether you thought of a celebrity like Warren Buffett, a less famous (but no less successful) hedge fund manager like Seth Klarman, or reached into the past for the likes of John Templeton or even Benjamin Graham, you have very likely named a value investor. Value investors are known for their academic nature, their patience, and their ability to diverge from the Wall Street groupthink. But most of all, they are known. 
This venerated group of investors, however, has been having a tough time. Granted, looking foolish is often part of the job description, since the most exciting times in the market—the go-go ’80s, the dot-com ’90s, the perversely bullish teens—are all about growth. After two, maybe three years, investors who stubbornly refused to overpay for skyrocketing stocks, recover. Usually. But for seven of the past 11 years, value stocks, and many of the people who own them, have languished. It’s getting tiresome even for those famous for their patience.

“About four years ago, we noticed that value investing had stopped working the way it had always worked,” says David Winters, veteran value investor and manager of the $293 million Wintergreen fund (ticker: WGRNX). Similarly, John Rogers Jr., founder of the $13 billion value fund shop Ariel Investments, recounts how he has lamented value’s challenges over dinner with other fund managers, “but, ultimately, we decided it would give us opportunity if we just stay disciplined. And patient.”

Value investing should work. At its most basic, it’s buying stocks that are cheap and holding them until the rest of the market realizes these great companies are selling at a bargain price, and pile in, driving prices up. Endless research has been done on the so-called value factor; the most well known was published by economists Eugene Fama and Kenneth French. Using decades of data, the duo posited in 1992 that value—buying the cheapest stocks and selling the priciest—was one of three factors contributing to outperformance. Over the long term, that has generally been true. But since 2006, growth stocks—shares of companies whose earnings are growing at an above-average rate—have outpaced value stocks, especially in the U.S. This has caused consternation and speculation: Is value dead?

Not by a long shot. Three factors are at work, according to value managers. First, there are signs that the market will soon turn in value’s favor. Changes in the market and the rise of passive investing have made active management all the more important. And some of the classic measures of value aren’t working as well—which could lead to a broadly different definition of value itself.

Are Value Stocks Ready to Grow Again?

“This time it’s different” has long been a rallying cry of growth investors who dismiss traditional ways of evaluating stocks, like during the dot-com boom when “price-to-eyeballs” became a thing. But inside GMO, the $71 billion asset manager co-founded by Jeremy Grantham, managers have been debating the dangers of always assuming that things are never different. That has led them to question whether mean reversion (the tendency of prices to move back to historical averages over time) is the inevitable outcome it’s thought to be and whether stocks could stay at higher-than-average prices. “That was a significant concession,” says Matthew Kadnar, member of GMO’s asset-allocation team.

“In the past, investors could just be very disciplined and stay clear of the glamour stocks and bubbles and buy the ugly,” says Bruce Greenwald, who has trained a generation of value investors at Columbia Business School, where he is co-director of the Heilbrunn Center for Graham & Dodd Investing. “That’s changed. It has gotten harder.” 
To be fair, value stocks have had a good run, just not quite as good as growth stocks. Over the past decade, the Russell 1000 Value index has returned 102%—not too shabby, but significantly less than the 178% for the Russell 1000 Growth, and behind the broader market’s 137% return.

Still, that 102% has made life easier for most value managers, in that outflows from their funds haven’t been as dramatic as they were during the tech boom. Jean-Marie Eveillard recalls those days with bemusement now, though they were painful then: “Sometimes, I got home and said to myself, ‘What is it other people are seeing that I don’t seem to be able to see?’ It was very painful for three years in a row—in ’97 [his investors] were disappointed, in ’98 they were furious, and in ’99 they were gone.” Then the president of SoGen Funds, Eveillard saw the assets in his funds fall from $6 billion to $2 billion. He soon migrated his business and is now a senior advisor at First Eagle Investment Management, where he helps oversee some $116 billion. “Investors should have a genuine long-term view. Value investors haven’t lost money; they just made less money than more aggressive investors.”

Many of the conditions holding value back are temporary. When the Federal Reserve began its quantitative easing to expand the money supply, bond yields came down, stock prices went up, and investors became less and less discerning as the market rose. Plus, anemic economic growth meant that investors were willing to pay up for the companies that were growing: While value stocks’ earnings have risen just 23% over the past decade, growth stocks have risen 44%, according to Leuthold Group.

All of that made for an inhospitable backdrop for bargain hunters who favor companies with strong balance sheets and low price tags. But that’s starting to change. As Thomas Lee at FundStrat Global Advisors notes, it has been “several generations” since we’ve seen stocks with price/earnings ratios this low this late in a bull market, which bodes especially well for low-P/E value stocks. Value stocks are trading at 13.5 times forward earnings; the FANG stocks— Facebook (FB), (AMZN), Netflix (NFLX), and Alphabet’s Google (GOOGL)—are trading at nearly double that, though a still surprisingly low 24 times, Lee wrote in a note last week.

What’s more, since 1928, rising interest rates have led to value outperformance, according to Lee. Everyone admits that pinpointing the turning point is impossible. But Sarah Ketterer, who co-founded the $58 billion Causeway Capital Management in 2001 and has been a value manager for some three decades, sees reason for optimism. “We are very early in the turn of this cycle; investors will eventually favor stocks that are more complicated or have internal problems, but are worth a look.” (For stock picks from Ketterer and other value managers, see the table above.)

Adding to the problem, this unusual economic environment coincided with the rise in passive investing. As money poured into market capitalization-weighted indexes, the priciest stocks became even more so, while the neglected stocks in value investors’ portfolios become further unloved. The makeup of the value benchmark has also hurt: Financial and energy stocks account for two of the three biggest sector weightings in the Russell 1000 Value index, accounting for 43% of assets. Financials was the worst-performing sector over the past decade, and energy over the past five years. Meanwhile, technology, the best-performing sector over the past five years and second-best over the past decade, represents just 9% of the value index, but a third of the growth index. “Passive investing clearly has exacerbated the situation,” Rogers says. “In the short term, it’s a self-fulfilling prophecy.”

Re-Evaluating Value

The rise of index investing has simplified the definition of value to a series of rules or metrics that can be used to create an index—a process that runs counter to the style’s roots. Value investing has a nearly 100-year history rich in academic research and big personalities running distinct portfolios. Benjamin Graham and David Dodd are credited with creating the value discipline in the 1920s, with tenets like buying stocks with a “margin of safety” to buffer unexpected developments. This created a lineage: Graham mentored Warren Buffett, who made a career of finding companies trading below their intrinsic value. Buffett, of course, has inspired countless disciples, such as Mohnish Pabrai, Prem Watsa, Bill Nygren, and a host of other hedge fund and mutual fund managers who have put their own spin on value.

That spin is where things get interesting. Some managers have broadened their approach. As global debt hits new highs, for instance, Charles de Vaulx, chief investment officer of the $19 billion International Value Advisers, says stockpickers who have been loath to incorporate economics into their analysis need to change their mind-set. “You’d have to be out of your mind not to,” de Vaulx says. “That doesn’t mean we are predicting interest rates, but you have to be aware. Debt magnifies everything.”

Some managers still use a deep-value approach, buying companies that investors have abandoned because of management or other business problems. Some, like Buffett, have gravitated toward great businesses at a “fair” price, but others will sit on cash if they can’t find anything cheap enough. Definitions of cheap vary, as do the processes used to determine “cheap”: Some managers use a flexible mosaic of factors; others stick with a more rigid statistical approach, focusing on metrics like price-to-earnings or price-to-book.

But there’s a problem with price/book: today’s economy. Price/book, perhaps the most conventional measure of value, evaluates stock prices based on a company’s book value—the worth of all tangible assets but no intangible ones. Price/book and similar accounting-based metrics worked better in an industrial-based economy, when companies owned valuable tangible assets, like manufacturing plants and equipment. Today’s service economy is filled with companies whose biggest assets are their brands, intellectual property, or customer loyalty, which don’t show up on the balance sheet.

Other trends, like stock buybacks, also skew the view from these metrics: On a balance sheet, buybacks can create negative shareholder equity, which can look like a sign of distress, says GMO’s Kadnar, who rebuilds balance sheets to make sense of what he sees as outdated accounting.

French has heard all of this before. The finance professor at Dartmouth College’s Tuck School of Business, whose work with Fama helped make price/book a classic gauge for value, maintains that price/book is still the best measure of value. “We have tested the hypothesis several times since then and haven’t been able to convince ourselves that another measure—including a combination of measures—is better, especially after we consider the effect on portfolio turnover,” French wrote Barron’s in an email.

Whether or not price/book is relevant, its effect on the index is undeniable and the reason that many active managers point to problems with the index. That may sound self-serving, but there’s merit to their argument: The Russell value indexes—the benchmark for $3.1 trillion in fund assets—are heavily weighted toward price/book, which makes up half of the calculation. Tom Goodwin, FTSE Russell’s senior research director, says the intention is to match the return patterns of self-described value active managers, which he says is captured by the index’s calculations.

But the emphasis on price/book has caused the index to underperform, and that’s one reason people think value overall hasn’t done well, says Ronen Israel, a principal at AQR.

In reality, active managers who don’t hew to the index can do much better. Bill Nygren, co-manager of the $20 billion Oakmark fund (OAKMX), has been among the few value managers to beat the market over the past decade, returning 11.2% annualized. “How you define value over the years has had to change,” he says. The underlying shift in the economy is one reason he owns stocks like Alphabet, Facebook, and Netflix. They might look pricey on certain metrics but are still values in his eyes—something that didn’t happen often in past cycles. Purists argue that veering into these higher-priced stocks is simply a way to boost returns, and Nygren has fared better than 98% of his peers, but he refutes any notion he is selling out. “We get to half Alphabet’s market value before even getting to its search business,” he says. “I can explain why I believe the business value for every stock in our portfolio is significantly higher.”

Nygren isn’t alone, and Greenwald says the shift in the economy warrants a more flexible approach: Service-oriented businesses tend to require higher market share to dominate, creating more monopolistic companies, with steadier and higher profits that could warrant higher multiples. Alec Lucas, senior analyst at Morningstar, points out that so many value managers have started buying what were traditionally considered to be growth companies that many value funds now pop up in Morningstar’s “blend” category. That willingness to own some nontraditional value stocks is one reason three-quarters of U.S. large-company value funds beat their benchmark last year, and 63% outperformed in the first quarter, a higher rate in both periods than growth managers.

Is this a turning point? The setup for value is certainly improving. Historically, value does better than growth when profits are accelerating, as they are now. Deregulation and tax cuts should boost sectors heavily represented in value indexes, like financials, industrials, and energy. The gap between the cheapest and priciest stocks has also widened since last year, providing an incentive for investors to look for cheaper options, Ketterer says.

Value’s recovery may be as delayed as spring’s arrival in the Northeast, but the green shoots are starting: Value stocks outperformed the broad market by 1.4 percentage points this past week, the best week for value stocks in more than a year. If nothing else, investors seem to be tiring of paying up for, well, not much. The S&P 500 Consumer Staples Sector Index, for instance, ended 2017 trading at a whopping 19.8 times 12-month earnings estimates, above the S&P 500’s 18.2 times, despite expectations that its sales would grow at a rate that is half that of the S&P 500 as a whole. Staples have tumbled 11% since then—the S&P 500 is close to flat—and while that might not be a sign that investors will suddenly rush into value stocks, it does suggest that they’re losing patience with high valuations.

“If the market gets out of its Goldilocks stage and the economy gets hotter, or the markets get colder—either way, value will work,” says Scott Opsal, research director at Leuthold Group.

No one expects the “value premium”—the extra returns typically ascribed to buying stocks cheaply—to disappear. But Kadnar says he doesn’t think the value factor can deliver the historical four-percentage point outperformance over the S&P 500 that it has historically. Though cheaper than the market, value isn’t nearly as inexpensive as in 2000.

Ultimately, the key is patience. “There are so few of us left,” Winters says. “You have to have investors out there who still believe in buying at a discount. I don’t know when, but at some point it will come back.”

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