Great rotations: The value factor
In the world of investing, a factor is any characteristic that helps drive the performance of a particular asset class. Value is categorised as a ‘pro-cyclical’ factor, meaning it has tended to benefit during periods of economic expansion. Higher interest rates reduce the value of companies’ future earnings, which weighs more on growth companies with their profit expected in years ahead. Value stocks are less sensitive to changes to macroeconomic conditions and have a history of emerging as the winning ‘factor’ following a recession.
At the end of 2021, the value factor performed well as the US Federal Reserve signalled that it expects to raise interest rates faster than expected given inflation concern. Value stocks are becoming increasingly appealing to investors who have sold down growth stocks as bond yields rise. In Australia, the 10-year government bond yield is trading around 1.94%, up 36 basis points over the month to 19 January while 10-year US Treasuries are trading at 1.87%, up 47 basis points. We are likely to see 10-year government bond yields reach over 2% this year as inflation fears mount.
THE RETURN OF RISING RATES
Driving up bond yields is higher inflation in developed countries worldwide. In the US, inflation exceeded 7% in December, the seventh consecutive month in which inflation has topped 5%, and well above US Federal Reserve’s long-term target of 2%. Over 2021, the US inflation rate rose to 6.8% over the last year to its highest point since 1982. Prior to the end of the last quarter, markets and US Federal Reserve had shrugged off concerns about rising inflation, citing that the drivers were ‘transitory’ as opposed to persistent, expecting inflation to ‘cool off’.
That has changed. The chairman of the US Federal Reserve, Jerome Powell, said of ‘transitory’, “I think it’s probably a good time to retire that word and try to explain more clearly what we mean,” during a congressional hearing at the start of December 2021. Financial markets reacted almost immediately, with rate rises expected as early as this year and inflationary pressures expected to persist. Some analysts are predicting as much as seven official interest rate rises in the US this year alone.
In Australia, with inflation running at around 3% per annum level, and interest rates expected to rise at least once this year, the economic environment is expected to support value companies, including cyclical stocks. Australian value companies that can maintain or increase margins without impacting on demand will be the ones who will win. In contrast, growth stocks, including highly-priced technology shares, could continue to suffer in 2022.
THE IMPACT ON EQUITY MARKETS
The recent outperformance of value is not an historical aberration. Since the turn of the century, the value factor has outperformed the MSCI World ex Australia index, despite its ‘lost decade’ post the Global Financial Crisis. Value companies typically outperform when inflation and interest rates increase, as they are less sensitive to changes in macroeconomic conditions. High inflation and rising rates were characteristics of markets in the late 70s and 80s, when value stocks outperformed.
Value has several dimensions including the stock price as a multiple of company earnings, price as a multiple of dividends paid, price as a multiple of book value, and other such ‘ratio descriptors’. But at the core of value investing is the belief that ‘cheaply’ valued assets tend to outperform ‘richly’ valued assets over a long horizon.
The concept of value was developed by economists Benjamin Graham and David Dodd, who advocated owning companies that provide a ‘margin of safety’ – meaning the current stock price is less than it is expected to be under conservative projections of the firm’s future earnings. Graham and Dodd believed that the true value of a stock could be determined based on its assets, future earnings, dividends and prospects. The lower the price of the security relative to this intrinsic value, the higher the ‘margin of safety’ and the potential for outperformance.
Over the very long term this has proven to be true. One of the world’s most successful investors Warren Buffett and his investment company Berkshire Hathaway have made a fortune using the principles of Graham and Dodd’s. Buffett has made a career identifying value companies when others have been selling.
Key to Buffett’s success has been identifying real value stocks and avoiding the cheap and nasty. A low price alone does not indicate good value, and those who pursue low price alone can easily fall into ‘value traps,’ or ‘trying to catch a falling knife’.
The performance of factors can be cyclical. Value has been used by savvy investors to diversify their other exposures, by combining approaches. Exposure to the value factor can be achieved through a variety of investment products, including actively managed funds and exchange traded funds (ETFs) based on factor indices. MSCI Factor indexes, for example, are designed to capture the return of factors which have historically demonstrated excess market returns over the long run.
For those after a low cost, transparent and accessible solution, value ETFs can be used by investors to diversify their portfolios beyond the Australian value share market, which is dominated by the big banks and miners.
The VanEck MSCI International Value ETF (VLUE) for example, offers access a portfolio of international companies that are selected for their high value score relative to sector peers as measured by MSCI based on: (i) price to book value; (ii) price to forward earnings; and (iii) enterprise value to cash flow from operations.
Based on back testing, the index VLUE tracks (net of VLUE’s 0.40% p.a. management costs) displays strong long-term performance.
The value outperformance is long overdue, coming after a decade of underperformance. The value rotation will likely continue into 2022 as inflation is not likely to go away as long as the COVID-19 pandemic strains the global supply chain and labour markets continue to tighten with emerging labour shortages, which have been exacerbated by the spread of the Omicron variant.
Inflation is likely here to stay for some time and investors need to position accordingly.
Russel Chesler is head of investments and capital markets at VanEck.
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