Ideas Farm: Half truths about the value revival

Value investors are finally enjoying a revival in their fortunes after 16 years when falling interest rates led to underperformance… right?

This popular narrative is actually only half right in theory, although it’s been entirely right in practice during the value rout. This needs some explanation.

The reason lower interest rates and inflation expectations are perceived as being better for growth stocks than value stocks is that more of the worth of growth stocks is based on future earnings. When interest rates are low, money in the here-and-now is less valuable. A higher value can therefore be put on income that is expected in the future. Growth stocks offer investors more income in the future. By contrast, value stocks tend to have poor growth prospects so their valuations are rooted more in the here-and-now. 

So while low interest rates should increase the valuation of both growth and value stocks, the valuation of growth stocks should increase by a lot more. This is what we’ve seen over the last 16 years during which growth has massively outperformed value and the valuation gap has got to historic highs on several measures.

However, in a recent paper, investment firm GMO points out that of itself this does not explain the underperformance of value investors. The reason for this is there should be another dynamic at play for value strategies that benefits from a wider valuation gap. 

The key reason for the previous long-term outperformance of value strategies is the profits to be reaped from cheap value stocks re-rating to become expensive growth stocks. The wider the valuation gap, the bigger the gains from this source. At the same time, growth stocks fall out of favour and provide a fresh supply of stocks for value investors. This is the key source of historical outperformance for value investors.

This is an important thing to understand. But the really interesting thing is that in practice this does not seem to have happened over recent years. Indeed, a paper from 2020 by Research Affiliates, which broke the long-term performance of value investing down into its component parts found the exact opposite happening from 2007 to mid-2020. The benefit of the re-rating effect dropped to 1.1 per cent a year over the period compared with an average of 5.9 per cent in the preceding 44 years.

While it is encouraging that the engine driving value’s long-term outperformance was still chugging even during the strategy’s darkest days, should value investors be worried? Has a period of unprecedented disruption and concentration of growth among a few monopoly players broken the historic relationship between the valuation gap and value’s re-rating upside?

This is possible. But, equally, it would seem foolhardy to write-off the chances of such a long-term relationship reasserting itself, especially if regulation and the spread of technology start to see big tech give up some of its growth advantage. It’s an interesting question and a pertinent one given value’s recent comeback as interest rates on government bonds have bobbed back up to pre-pandemic levels.

We certainly know which side of the bread is buttered for GMO: “Given the wide discount at which value stocks are currently trading globally, we expect value to continue to outperform the market over the next few years, but that belief neither assumes nor requires any particular moves in interest rates.”

Research Affiliates is singing from the same hymn sheet (or eating from the same loaf for those who don’t like their metaphors mixed).

Big picture stuff aside, though, there will always be growth stocks that do well and value stocks that do well even when the tide is against them. Our list of fund managers' favourite tech shares this week may give some clues where some of the best growth opportunities lie.