The current resurgence in value stocks calls for a discerning eye to gauge the different factor exposures driving the value rotation.
Value’s resurrection began late last year as COVID-19 vaccine distribution campaign geared up and expectations for economic reopening increased. This coincided with a market shift that favored value stocks over more expensive companies exhibiting stronger levels of earnings growth. This trend has largely continued into 2021 as market and economic growth prospects appeared to brighten.
Advisors may be forgiven the need to reacquaint themselves with value — the last time value outpaced growth Sen. Barack Obama had announced his candidacy for president of the United States. Identifying value strategies best positioned to outperform requires nuanced due diligence because not every manager looks at value the same way, defining it on a fairly broad spectrum leading to a variety of styles ranging from deep value on one end, traditional or classic value in the middle and quality value at the opposite end.
Deep value managers tend to be overweight (relative to the Russell 1000 Value index) on traditional value characteristics like book-to-price, cash flow yield and dividend yield. A quality value manager, on the other hand, tends to underweight the benchmark on traditional value characteristics while overweighting growth factors like earnings growth, return-on-equity and momentum, among others.
Dot-com precedent
In the five years leading up to the recent rotation in September 2020, deep value managers faced significant headwinds relative to quality value managers. Indeed, deep value strategies lagged as investors favored quality and sustainability of earnings relative to steep valuation discounts and economic sensitivity.
But notwithstanding value’s recent struggles, the investment style has generated solid results over longer periods of time. Managers across the value spectrum delivered excess returns to investors through full-market cycles over the last 30 years.
It bears noting that a highly similar trend occurred in the period leading up to the dot-com bubble of the late ’90s as investors gobbled up growth names at any price. Following the 2000 crash through 2006, deep value managers outperformed as investors rotated away from growth stocks toward more cheaply priced companies and cyclical beneficiaries as economic conditions strengthened. While the anomalies for both that and the most recent period are markedly different, they both triggered market rotations favoring the deep value investment framework.
Bearing this in mind, we recommend that advisors consider increased allocations to deep value. The rotation within value since September 2020 has been significant, with deep value managers delivering significant excess returns relative to quality value managers for Q4 2020 and Q1 2021. This mirrors post-dot-com-bubble behavior where deep value investors were rewarded as more clarity on future economic stability was provided.
Overall, we believe there is no solitary correct way to approach value investing; over the long term, a variety of management styles have outperformed the value benchmarks utilizing approaches ranging from deep value to more quality or relative value strategies.
That said, using history as a guide, deep value managers appear poised to outperform as we gradually shed the challenges posed by the pandemic and round into a potential phase of continued economic recovery.