An overdue market rotation

Value has seen the biggest turnaround since World War II with value managers being vindicated after years of underperformance. 

Value had underperformed growth for over a decade in an environment where interest rates have fallen which benefits growth stocks as they are longer-duration assets. This means they have more of their cashflows in the future than a short-duration value stock. 

Companies have also struggled to find earnings growth in a weak economic environment as profits are under pressure which meant investors paid a premium.  

But since the announcement of the COVID-19 vaccine from Pfizer and BioNTech in November, value stocks have seen a sharp turnaround.

In the six months from October 2020 to March 2021, the S&P Australia BMI Value index beat the S&P Australia BMI Growth index by 19.7%, the strongest six-month period on record. 

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Meanwhile, the MSCI ACWI Value index had returned 27.4% since 1 November to 17 June, 2021, compared to returns of 10.6% by the MSCI ACWI Growth index. 

“The numbers highlight in dramatic fashion how quickly the value premium- the additional return available over time from low relative price stocks – can kick in,” said Bhanu Singh, head of Asia-Pacific portfolio management at Dimensional. 

“This is the sharpest turnaround we have seen since World War II, especially in the US, and it comes hot on the heels of a market drawdown.”
When there was an economic recovery, values names tended to bounce back stronger than growth ones while expectations of rate rises penalised growth names and favoured short duration assets instead.

Sectors which were particularly benefitting were commodities, housebuilders, agricultural companies and financials and value managers described how they were overweight to these sectors but stressed value was an overall portfolio theme, rather than a style limited to individual sectors.

Within the ASX 200, the financials sector returned 44.6% since the start of November while the energy and resources sector had also seen returns of more than 20%. 

Others pointed out that it was not necessarily the fact that value was outperforming but rather that growth stocks were performing worse than they had done in the past.

Sinclair Currie, principal and co-portfolio manager at Novaport Capital, said: “Several years of strong performance by growth themes reinforced investor confidence in companies exposed to these trends. As a result, investors steadily raised the valuation premium for these companies. This created a yawning valuation gap relative to companies which did not enjoy the benefits of those thematic tailwinds. 

“As time has passed many of these growth themes are now showing signs of maturity. Some remain robust however others are not maturing well and compare unfavourably to emerging themes. Rather than point to a generally positive environment for value, we highlight that many of the companies exposed to the newly emerging investment themes have substantially more attractive valuations. This is driving a rotation of market leadership.”

“It is a combination of both,” said Hamish Tadgell, portfolio manager at SG Hiscock, “growth stocks have de-rated, some tech companies have fallen by 30% to 40% but at the same time, value-orientated ones have been rallying.”

However, managers were modest and declined to signal that this period of outperformance was a ‘victory’ for them after years of their chosen style being out of favour. They said investing as a value manager required discipline as markets could move very quickly and a systematic, fundamental investment process which could be explained to clients in periods of underperformance. 

“While the recent performance has clearly been pleasing for value managers, I still think it is a bit early to claim victory! Value has had a very tough decade and the recent outperformance only began less than a year ago,” said Dougal Maple-Brown, head of Australian equities at Maple-Brown Abbott.

James Williamson, chief investment officer at Wentworth Williamson, echoed: “If any value manager worth their salt calls the last few months a victory than they are setting a very low bar for themselves”.

INFLATIONARY ENVIRONMENT

Managers said they expected value stocks to do better than growth stocks in a high-inflationary environment and a favourable economic environment would also highlight the lofty valuation multiples of growth stocks.

According to Bank of America, the threat of rising inflation had been the biggest tail risk for global fund managers for several months and 64% of respondents were expecting inflation to rise over the next 12 months. 

Tadgell detailed the theory of a regime shift, of which there had only been eight in the last 100 years. 

“A regime shift is when we see rising inflation and then it moves materially higher to around 5% or more, equities struggle in that case but cyclicals and commodities tend to do better as real assets outperform equities in that type of environment. 

“Until now, we have been in a deflationary environment but when does that break and we move to an inflationary phase? There is likely to be shift towards an inflationary regime rather than lower interest rates.”

Maple-Brown said: “A reason value should do well in a high inflationary environment is that commodities, still one of our favoured sectors, historically have provided a reasonable hedge to inflation. Now every cycle is different, indeed individual commodity markets can be quite nuanced, but we would expect this historical relationship to hold”.

Lewis Grant, senior global equities portfolio manager, at the international business of Federated Hermes, said: “The unleashing of pent-up demand onto fragile supply chains still reeling from the pandemic has driven inflation expectations higher, with the debate shifting from whether we would see inflation to whether it will last.

“An inflationary environment will be supportive for value names, even if the Federal Reserve maintains course. Eventually, we are likely to see some form of taper tantrum but this will further support the case for value names.”

“We expect companies which are able to pass through cost inflation to outperform in a high inflation environment. Some (but not all) companies currently in the ‘value’ basket appear well placed for a high-inflation environment. For example, industries with sunk capital and high operational leverage present an interesting opportunity in a high inflation environment,” said Currie. 

TIME TO ROTATE PORTFOLIOS?

So, should investors consider moving their portfolios into value stocks or have they missed the bulk of the rally? Managers said there were expectations that value could continue to outperform for several more months so there was still time to get in on the trade. 

However, they said value was an “evergreen principle” which investors should hold a long-term allocation to it rather than taking a temporary position.

Maple-Brown said: “Essentially growth has outperformed value for a decade and value has had a good six to nine months. Over the entire time, value has underperformed growth by approximately 50% and value has probably recaptured around 10% more recently. 

“So, whether you look at the time periods or indeed the underperformance, we would argue that value’s run is only just getting started.”
Tadgell said: “We moved from despair in March to hope very quickly then we entered the growth phase in October where we have been ever since and this is the longest phase. We have seen a pick-up in synchronised global growth but I expect it will slow in the second half of the year. 

“Growth will slow in the next few quarters and the question is how the market will react to that. I think value will remain attractive but the breadth of returns will broaden out, it won’t just be about growth versus value. We are already seeing healthcare and technology do a bit better in recent weeks.”

Singh said: “When you have six months of outperformance by value, then there is usually a six months follow-on from that. Value is an evergreen principle, it makes sense to have a long-term allocation to value rather than trying to time the market”. 

Ben Sheehan, senior investment specialist for Asia-Pacific equities at Aberdeen Standard Investments, added: “Over the long-term, we believe owning companies that are exposed to structural growth will do well regardless of the value versus growth regime as the importance of strong stock selection should ultimately transcend the importance of style factor performance.

“A balanced portfolio of value and growth stocks can provide exposure to cyclical and structural growth forces. This may be a more prudent approach than choosing one style over another.”