In theory, the COVID-19 market crash should have provided value investors some respite following a decade of underperformance. Multiples were highly stretched ahead of the crisis and many believed a significant correction would provide impetus to cheaper, less fashionable companies at the expense of overvalued technology stocks.
The reality was painfully different. March was the third worst month for value relative to growth for 45 years as we all depended on technology, healthcare and companies providing consumer staples during lockdown. Conversely, traditional value stocks such as financial services and energy struggled amid record low interest rates and oil prices, while companies with higher debt levels were also marked down.
Previous drawdowns, however, show that value often underperforms in a falling market. Since 1975, it has lagged in 38% of months when the MSCI World index has been negative, rising to 48% when the drop has exceeded 5% (the index fell 13% in March)[1]. Looking further back to 1963, analysis from Research Affiliates examining six previous crashes reveals that value only outperforms if the crisis is preceded by an asset bubble, as opposed to an economic shock like the coronavirus[2].
It has created a record reversal of the long-standing 'value premium' (see figure 1 below) and led some to question whether value has a future. There are signs, however, that a tentative recovery is underway. Value stocks have outperformed growth since the market nadir according to the respective Russell 1000 U.S. large-cap indexes while the majority of our own funds delivered relative gains in May.
Turning the tide
As countries around the world exit from lockdown, so far without causing a significant COVID-19 wave, focus has turned from the health crisis to economic repair. The recovery phase has historically been supportive for value stocks as companies perceived to be higher risk benefit from growing investor appetite. Growth stocks also appear vulnerable with current valuations still stretched and predicated on continued earnings growth that is far from certain. Even if we avoid a second spike of infections, high levels of debt and unemployment mean economic challenges remain, while political uncertainty from US elections and Brexit is also on the horizon.
History also teaches us that when the growth to value spread has been at levels close to today's – the MSCI World Growth index P/B is over double that of the value equivalent and its P/E more than three times higher – value outperformance follows. For this not to happen again, growth stocks would need to deliver further earnings growth or interest rates used to discount future earnings would need to fall further, both of which seem unlikely.
Riding the wave
For investors, it ultimately boils down to price and how much you are willing to pay for the cash flow you will receive. According to Exane BNP Paribas, the lowest valued quartile of European stocks traded at a 73% discount to the highest on a P/E basis at the start of June, well below 2012 and 2016 (56%) and even cheaper than the 65% concession in 2009 following the financial crisis. Value has since been positive over the last 14 days, but significant opportunity remains. In order to have the best chance of capturing it, I advise three things:
- First, be selective. There will inevitably be winners and losers along the road to recovery and a discerning approach to company selection will be rewarded. While a broad tilt towards value may well pay-off in a V-shaped economic recovery, stronger businesses with more dependable cash flows will provide better protection if the revival is slow or we face an extended period of uncertainty.
- Second, be pragmatic. It is important to look beyond what's optically cheap and really understand the drivers of company cash flow using detailed research. The world is facing considerable change and the valuation techniques of the past may not be the best guide to success in the future.
- Third, be nimble. While a long-term investment horizon will continue to provide the best portfolio returns, volatility will remain high as we make tentative steps towards recovery and having the flexibility to take opportunities can only serve to further increase those gains.
Despite the profound changes caused by the COVID crisis across many areas of life, one constant is likely to be investor irrationality. The decade-long gap between value and growth could well be on the cusp of a meaningful rotation, which represents a truly generational opportunity for investors brave enough to go against the crowd and sufficiently skilful to pick the right stocks. Similar dispersions can currently be seen in small versus large caps and emerging versus developed markets, which I will explore in future updates.
References
[1] Source: Is there Still a case for value, Mercer, June 2020
[2] Source: Value in Recessions and Recoveries, Research Affiliates, June 2020