17 June 2021





WHY YOU SHOULD CONSIDER VALUE STOCKS: ALL YOU NEED TO KNOW




By Raul Elizalde

This article also appeared on forbes.com


Value stocks have fallen behind growth stocks in the last few years. This divergence grew faster in 2020, but both categories started drifting apart well before then. As the economy heads towards a full reopening, this condition may be coming to an end, giving investors a rare opportunity to invest in a category of stocks that seem to be undervalued.


In investment parlance, value stocks are those that trade at low multiples to their “fundamental” worth, measured by book value, sales and earnings. While there are various methodologies to calculate this, “value” stocks are those with a low price relative to those metrics, while “growth” stocks have a high relative price.

source: Federal Reserve Bank of San Francisco
Both styles started to move away from each other after the 2016 election. One possible reason may be the sharp redirection of U.S. economic policy, which starting in 2017 focused heavily on cutting taxes for businesses. This may have favored technology companies, a sector dominated by growth stocks, as lower taxes swelled their already big coffers and sped up stock buybacks that were already pushing their stock prices up.


That taxes may have been an important reason is reflected in other measures such as operating margins per share, which exclude taxes. By that yardstick, the difference between technology sector (growth) and financial sector (value) stocks, for example, does not appear to justify the outperformance of the former, suggesting that tax policy may have indeed been an reason behind the divergence.


A related issue is that the price gains of growth stocks in the last three years have been driven mainly by multiple expansion rather than by better fundamentals, even when taking into account the pandemic months. Northern Trust NTRS -1.7%, for example, points out in a recent note to advisors that while earnings-per-share for growth stocks grew 10% more than for value stocks since 2018, their price/earnings ratio climbed by an astonishing 140% more.


It is remarkable, however, that this phenomenon was not confined to the U.S. markets. It happened all over the globe, so it is not clear that business tax cuts were the only reason for the distortion, or if it was, by what mechanism U.S. business tax cuts may have caused a similar divergence across international equity markets. Whatever it was, the impact on the relative performance of both style categories was pronounced.

source: Federal Reserve Bank of San Francisco
This was even more acute during the pandemic, which gave a push to the revenue of tech giants since they were best positioned to satisfy the needs of a locked-down population. Other industries, meanwhile, had to shut their doors for months.


When the U.S. economy started to reopen, in many ways faster than anticipated, a rotation out of high-flying growth stocks and into depressed value stocks started to take place, but it seems to have stalled in the last few weeks and go in the opposite direction.


Some pundits have been quick at declaring the rotation into value stocks over, and calling for renewed investing in growth stocks. They may be making the wrong call. Growth stocks have been more volatile, and a temporary change of direction is to be expected. The case for value stocks, on the other hand, is largely intact.

source: Federal Reserve Bank of San Francisco
Growth stocks do not just look overpriced but are also in a worse position than value stocks to benefit from the short- and medium-term economic outlook. Value stocks are largely cyclical and, as such, poised to benefit from the highest savings rate on record, an accelerating economy, high corporate earnings projections and a strong return to usual consumer spending patterns. History shows that these conditions accrue considerably more to value than to growth stocks.


The recent pause in the rotation into value seems to correlate with lower U.S. Treasury rates, a condition that we, as many others, believe to be temporary. Recent inflation numbers have been very high, and although the latest 4%-5% reads are unlikely to persist, there is also little doubt that it will settle well above 2%, significantly higher than where the 10-year U.S. note is currently trading. It seems just a matter of time for interest rates to rise, which historically has been much more beneficial to value stocks than to growth stocks. How to buy value stocks


An efficient way of gaining exposure is through exchange-traded funds (ETFs). IWD and IVE are two value-style iShares ETFs that track the Russell 1000 Value index and the Standard & Poors’ 500 Value index, respectively, and IWF and IVW are the Growth indices counterparts. Investors seem to prefer the Russell 1000 index, given that they attracted more than twice the assets than the S&P-based ETFs.


A notable fact is that value and growth ETFs feature similar stocks, but in different proportions. This is because each holding is assigned a weight depending on how high or low it ranks on the scale of the fundamental measures of book value, sales and earnings. Alphabet and Home Depot HD -0.3%, for example, are among the top 20 holdings in both IWF and IWD, albeit in different proportions.


Some ETFs avoid overlapping any holdings, such as the much smaller Invesco’s IVZ -1.1% RPG (Pure-Growth) and RPV (Pure-Value) ETFs, which are benchmarked against the Standard and Poors’ Pure-Style indices. While an investor would get a sharper differentiation, the downside is that Pure-Value ETF seems to be much more concentrated in the finance sector than other value-style ETFs.

source: Federal Reserve Bank of San Francisco
Pure-style ETFs have been more volatile than the broader style ETFs, a factor that may be important to some investors. Higher volatility may also lead to different returns, which could be an argument for a basket containing the three value ETFs discussed above rather than choosing a single one.


Regardless of the vehicle, the evidence clearly suggests that value stocks are cheap. Opportunities like this don’t come too often, and investors should give it serious consideration.


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