Value investors have had a bad time recently. In the last three years total returns on value stocks (as measured by the FTSE 350 higher yield index) have been just 4 per cent, compared with 32 per cent on the lower yield index. Deep value stocks have done even worse; my portfolio of the 20 highest yielders has fallen almost 30 per cent in price terms in this time.
The past three years, though, only continues a longer-term trend. In the last 20 years the FTSE 350 high yield index has underperformed its low yield counterpart by 1.4 percentage points a year, even including its higher dividends.
Older readers can be forgiven for being vexed by this. For years the conventional wisdom, inspired by Benjamin Graham’s work in the 1930s and 1940s, was that value stocks were better investments. Which for a long time they were. In a famous paper in 1997 the Nobel laureate Eugene Fama and his colleague Ken French pointed out that value stocks had outperformed growth stocks around the world for years.
So, what changed? This might be an example of Murphy’s law. When investors learn that a type of stock has outperformed in the past they pile into it. But that pushes those stocks up so far that they subsequently do badly – sometimes for many years. What happened to small caps in the 1980s and 1990s has been the fate of value stocks in recent years.
Something else has happened, though, which offers a glimmer of hope for value investors.
My chart shows what. It shows that the long-term underperformance of value stocks has come at the same time as a downtrend in long-term real interest rates. More remarkably, the exceptions to the trend in real yields have also coincided with exceptions to value’s underperformance. The few cases of rising real yields – in 2008 and in 2021 – also saw value outperform. And when real yields moved sideways between 2012 and 2014 and in 2017-2018 so too did value relative to growth.
Coincidence?
No. There’s a simple reason for this link. Growth stocks offer cashflows in the more distant future than do value stocks: that’s what growth means. Lower bond yields, however, mean that investors apply lower discount rates to future cashflows, raising their present value. Which causes growth stocks outperform value when yields fall. Long-duration assets outperform when long-term yields fall, and growth stocks are longer-duration assets than value ones.
Of course, bond yields are not the only influence upon the relative performance of growth and value. Value stocks have tended to do badly when the All-Share index and sterling have fallen. This is because all three are cyclical assets, doing well in good economic times and badly in bad ones such as 2008-2009 or early 2020.
Herein lies the hope for value investors. If or when the long-term downtrend in real yields stops, so too should value’s underperformance.
We must, however, be careful here. The question is: why might real yields rise?
One possibility is that they would do so as investors anticipate higher real short-term interest rates as central banks tighten monetary policy. What matters here are US interest rates as well as UK ones: bond yields are determined by global forces.
In this case, if value stocks outperform they could do so only by falling less than growth stocks. And they might not achieve even this. If investors fear that tighter monetary policy would do serious economic damage, they would dump cyclical value stocks even more than growth stocks.
The much nicer possibility for value investors would be if bond yields rise because markets anticipate stronger economic growth. In this scenario value stocks such as miners and housebuilders would benefit from investors’ greater willingness to take on cyclical risk. And they’d benefit relative to growth stocks as higher yields cause investors to dump the latter in favour of shorter-duration stocks.
Sadly, though, this prospect is far from guaranteed. The pandemic has done nothing to weaken the long-term causes of secular stagnation. And higher energy and raw materials prices, plus a fiscal tightening in the UK, could actually depress growth next year. There’s a big risk, therefore, that value investors will suffer further disappointment. Your fate as a stock-picker depends more than you realise upon macroeconomic conditions.
