Is now the time to buy value stocks?

Strong momentum across many markets has increased investors’ concerns about inflated valuations. As the “growth-at-any-price” trade seems to be fading, many believe a rotation out of growth stocks and into value may continue to outperform the broader market. Across the globe, equity markets appear to offer a lot of bargain opportunities, with banks, utilities, telecommunications companies, materials and energy producers trading at single-digit multiples and with dividend yields of 4% to 7%.

The age-old debate between growth and value continues. But before you rearrange your portfolio in light of the current rotation, here are a few things to consider.

Market data has become more accessible over time, leaving fewer undiscovered opportunities. Quantitative funds using algorithms to automate the process of rapidly scouring press releases, company reported numbers and even social media posts make simplistic strategies, such as buying stocks based on quantitative measures like low P/E or free cashflow yield, less likely to outperform the market. Ultimately, the value of an equity is the discounted future cashflows of the business. Market participants have become broadly aware that capital intensive businesses with volatile demand and pricing do not make for good investments, and companies have increasingly evolved towards maintenance, services and subscription models which are less economically sensitive. In other words, many cheap stocks are cheap for good reason. For instance, loan books of Chinese state-owned banks may hold greater credit risk than reported, a result of policy-directed lending towards highly indebted state-owned customers. A Japanese auto company facing the dual threat of weakening demand for sedans and internal combustion engines is another example. While value stocks may provide downside protection due to the low valuation and high dividend payout, outside of any potential short-term rerating, these stocks are priced low because the future cashflows for these companies are not expected to grow and may even deteriorate. Today’s value stock is not like your father’s value stock.

Over the long term, equity markets have historically offered returns around 10%, or closer to 7% adjusting for inflation. A stock with no earnings growth can only generate a return equal to its dividend. Since even the cheaper value names have yields below the long-term expected rate of return, on face value an investor would be losing out by buying and holding on to these stocks. However, it is also important to examine the impact of inflation on a business, especially as central banks risk over-shooting the monetary expansion used to compensate for the demand shock resulting from covid lockdowns. An oil and gas producer, for example, may see revenues grow in-line with inflation. So long as costs also grow in-line with inflation, ultimately earnings also would benefit. That isn’t a given, however, and often management is incentivized to acquire assets at precisely this time, risking over paying and resulting in an eventual write-down. A utility required to negotiate with a government in order to raise rates may not benefit as consumers revolt against price increases. Few businesses can escape the corrosive influence of inflation.

Equity valuations have a loose correlation to bond yields, whereby P/E ratios will increase to reflect the lower relative returns from bonds. With very low yields around the world, it is reasonable for equity markets to respond to this reality. In this environment, growth has become more highly prized and multiples have risen. Unless yields start to move up meaningfully, growth stocks may not be as expensive as they appear. A stock trading at 50 times P/E today is not the same as a stock trading at 50 times P/E 20 years ago, because the expected future rate of return is relative to all other possible opportunities at the time. The same could be said of the so-called value stocks. The reason valuations for value stocks did not go up to the same degree as growth stocks is more likely explained by a general expectation of a greater dispersion in the growth in cashflows among businesses.

Historically, value stocks have been expected to provide downside protection in the event of a broader market sell-off, such as the Global Financial Crisis or the Covid sell-off in March last year. In fact, for both historic events, very little proved to be defensive. More recently, the higher P/E growth stocks seem to be the cohort more resilient in the face of a market downturn. This could be due to a consensus view that a number of companies currently exhibiting high growth are structurally disruptive and will continue to grow through market cycles via market share gains. Hence, in the face of redemptions, fund managers may be less willing to choose to sell these stocks.

Research shows that investors tend to be too optimistic about the future growth of high growth stocks, and too pessimistic about the growth of low growth stocks. In the middle, between growth and value, sit businesses that generate growth well above market average, with strong fundamentals and fairly reasonable multiples—considering where rates are today. These are companies we consider high quality stocks. While it is fair to say that, at some end of the market, valuations for growth have gotten out of touch with even a reasonably optimistic expectation of growth, there are still opportunities for investors looking for long-term compounded growth. Companies that exhibit qualities such as pricing power, barriers to entry or strong competitive advantages lead to greater predictability of earnings. Additionally, buying quality businesses usually requires a longer-term holding period. Quality businesses are generally not unknown to the market and, thus, usually demand premium valuations. It is the quality factors of the business that allow it to compound at a more consistent rate over a longer period of time, which creates value for shareholders. As a result, quantitative managers who may own the same stocks tend to sell out of them earlier given the shorter-term nature of the holding period, meaning they tend to leave the real money these quality businesses can generate on the table.

At any given time, the extreme end of the market exists, where valuations are more speculative—especially new or emerging industries with limited track records. Electric vehicle makers and their suppliers or the latest crop of internet services companies continue to sell at valuations that are difficult to justify even under the most optimistic scenario. Investors could attempt to time the market rotating from these more speculative growth stocks to value, but the stocks that make up the value bucket today are likely appropriately priced relative to their growth opportunities. So, this rotation would make the most sense as a short-term trade. Experience reveals, however, that timing markets is a difficult, and perhaps an impossible, task. A market rotation is not usually obvious until well into it, coupled with many false starts and stops. But buying high quality business that can compound earnings over time should let you sleep at night, and over time should be more likely to help generate above market returns.

The views and opinions herein are those of the individuals mentioned above and do not reflect the opinions of Vontobel Asset Management or Vontobel Group as a whole. The views may change at any time and without notice. This document is for information purposes only and does not constitute an offer, solicitation or recommendation to buy or sell any investment instruments, to effect any transactions or to conclude any legal act of any kind whatsoever.