Investors have for years mused whether value investing as we know it is broken — and with good reason if they judged by institutional allocators and the financial news media. Back in 2008, Institutional Investor went so far as to declare value investing dead in the early stages of the mighty bull market that stampeded us out of the Great Recession.
But in 2021, the word you see many market participants associating with value stocks is “comeback.” The Russell 2000 Value Index has returned 25.75% year-to-date (as of Sept. 7), while the Russell 2000 Growth Index has clocked in at 8.36% over the same period. The tide has turned with the recovery of another crisis — the COVID-19 pandemic. The response to the 2020-’21 period of upheaval was unprecedented, with the U.S. government providing a historic level of fiscal stimulus as the Federal Reserve maintained easy monetary policy to make markets and keep the economy as stable as possible while the virus took its toll on the world.
Now Americans, many having received the COVID-19 vaccine, are emerging from nearly 18 months of sheltering-in-place with cash to spend. This tremendous release of pent-up demand is driving up prices at the gas pump, at the grocery store and in the housing market.
Though we share the Fed’s view that this bout of rising inflation will prove to be transitory, it is piquing investor interest in value stocks, as these companies have strong cash flow in the near term.
While the overall picture of value stocks looks interesting, speculation persists among investors trying to time the market and figure out how long value’s comeback will last. But such short-term speculation defies what we at Homestead Funds believe is the true meaning of value investing: conviction in a company’s management, its financials and its ability to compete in an ever-changing world. Buying a “cheap” stock based simply on low price-to-earnings multiples or price-to-book ratios and anticipating a bounce back to historic norms is not, we believe, a sound investment strategy. Rather, it’s the investors who kept a portion of their assets in value stocks — or better yet, in a diversified fund of high-quality value stocks — who are, in our opinion, now better positioned than those piling into performance trends.
Value’s smoke and mirrors?
The COVID-19 recovery has and will continue to benefit companies historically deemed value stocks. With the faster-than-expected pace of the economy’s comeback driving inflation upward, the Fed will be under pressure to raise interest rates. If the economy continues to grow at a fast pace, then businesses will need to invest. Financial stocks are poised to benefit, as corporate spending will drive loan growth. According to S&P Global, the financial sector was up more than 25% year to date as of July 30, and it is our value fund’s largest sector weight at 19.5% of the portfolio this year through June 30.
We are finding true value within the financial sector. There are quality companies within this industry that are not only undervalued at present but also historically and consistently profitable with favorable growth prospects and strong balance sheets.
We would place the recent COVID-19 rebound trade in the energy sector on the opposite end of the quality-value spectrum. This is one of the best-performing sectors so far this year; according to S&P Global, the energy sector has returned 39.24% year-to-date through May 28. Value investing trend-followers have rushed in, enthused by people using oil and gas as they travel and resume social activities that were sidelined by the pandemic. A pickup in industrial demand has also helped prop up the industry.
But we believe the investor enthusiasm for energy stocks in 2021 represents an overreaction to positive, albeit fleeting, news. There may be price support in the near term, but the supply and demand dynamics are less favorable over the long haul. We see a decarbonized future centered on renewables, and public energy companies having historically been poor allocators of capital. Changes in technology and governance measures have destroyed mean reversion in many industries, including energy.
Quality counts
Investors focused solely on buying stocks that stand to benefit from the re-opening of society may be missing opportunities born out of long-term secular trends. The health care sector has returned 17.33% year-to-date through July 30, according to S&P Global, yet we know from living through the pandemic how important these companies are to the world moving forward. We believe there are positive long-term prospects for the health care sector. As the U.S. population gets older, there will be more medicine, devices and services needed. Another positive trend for the sector is the further integration of technology into the industry to create and improve things like robotic tools for surgery and precision medicine.
Our value fund was more heavily weighted toward health care than the Russell 1000 Value Index this year through June 30. Many passive managers of value funds are forced to own stocks based on this predetermined index. In contrast, active stock investors like us have more flexibility to analyze and assess the long-term viability of companies — and therefore, more opportunity to potentially capitalize on opportunities and avoid future pitfalls. Through our firm’s history we have held firm that active management is essential to value investing, as it allows you to dig deeper into companies’ fundamentals and understand them in ways that passive managers simply cannot.
Now is not the time to be a passenger along for the ride of trends that could shift course at any moment. The turbulence of the COVID-19 pandemic has taught us that circumstances can change almost instantly. As long-term investors, we must turn down the noise and try to assess how a company might compete years rather than quarters from now. It does not matter if you call this approach quality, modern or just plain value investing. Funds that buy stocks with both durable earnings power and reasonable valuations should always play a role in your portfolio.