Value Investing Should Finally Have Its Day In The Sun
2018 Investment Themes series: Late-cycle theme #4
Value investing should finally have its day in the sun. Value stocks (i.e. undervalued stocks) will capitalise on synchronised global economic growth and mounting inflationary pressure. These pro-cyclical trends will drive up bond yields to which value stocks are positively correlated. The discount on value stocks should diminish during the first few quarters of 2018.
A different and diversification approach for equity markets
Investing in equity markets consists in selecting stocks, markets, sectors and styles. Typically, different approaches are combined to build a diversified exposure to shares with an excellent risk-return ratio.
A distinct bull market
Empirical research shows that over the long run, value (i.e. cheap) stocks tend to outperform growth stocks (companies with above-average earnings momentum). This (almost systematically) reflects an overvaluation of earnings potential for growth stocks, and by contrast, an undervaluation of value stocks.
Since the beginning of the bull market (March 2009), value stocks have underperformed growth stocks. The main reason for this is that the global economic recovery has been lacklustre, requiring authorities (particularly monetary) to take emergency measures to sustain it. As a result, bond yields have followed a bearish trend and equity investors have preferred to focus on the visibility on business performance and dividends rather than pro-cyclical positions.
In the first few months of 2018, the continued global growth should boost investor confidence in, and appetite for, value stocks. Eventually, these value stocks should outperform growth stocks for several quarters.
A period of outperformance begins
The wide range of positive contributions to growth (consumption, business investment, world trade and fiscal stimulus in certain countries) and synchronised world growth are sustaining companies’ earnings momentum. A favourable economic climate, coupled with rising inflationary pressure, will drive up bond yields. Although we expect only a moderate rise, we believe it will be enough to take value stocks into a prime position to outpace growth stocks as investor appetite for cyclical stocks returns.
Highly attractive valuations
The price-to-book ratio for value stocks is around its long-term average compared with above average for growth stocks. This means that value stocks are trading at a very attractive discount (nearly 55% versus a long-term average of 47%). This discount should diminish as bond yields rise.
In a context of sustained growth, mounting inflation pressure and rising bond yields, the time is nigh for value stocks to shine again.
Like any investment in shares, the risk of losing the capital invested will increase in the event of a general reversal on the stock markets.
However, the chief risk is linked to the direction of the economy. Assuming a deterioration, investor confidence would probably fade, and consequently, investors would retain their preference for growth stocks.
Consequently, value stocks would continue underperforming growth stocks.
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