Value stocks have been a natural beneficiary of the optimism pervading equity markets over the past two months. The sharp post-pandemic rally in global markets shows that investors are betting increasingly on an economic recovery. As the IC’s Algy Hall recently pointed out, this approach – based on the average performance of strategies backing the cheapest fifth of FTSE All-Share stocks – returned 32.2 per cent during the three months to 24 June, according to S&P Capital IQ data, above that of quality, growth and momentum strategies.
But this glimmer of outperformance is an about-turn from more than a decade of disappointment. The main question investors have faced since 2007 is whether this underperformance is structural or episodic, says O'Shaughnessy Asset Management director of research, Chris Meredith, a question he seeks to resolve in his research paper ‘Value is dead, long live value’. After extending revenue and earnings data for individual companies back to June 1926 – further back than most investor analyses typically go – and applying price-to-book, price/earnings and price-to-sales ratios, Mr Meredith concludes that it is the latter.
Value stocks broadly outperformed growth between 1926 and 2019 except for two windows within that period – June 1926-December 1941 and January 2007-December 2018. Both those time frames were preceded by technological revolutions, “clusters of new technologies that cause economic upheaval over periods lasting 45 to 60 years”, says Mr Meredith, referencing scholar Carlota Perez’s model of identifying such phenomena. Those periods of upheaval propelled growth stocks far above value. In 1926, manufacturing stocks were primarily in the growth portfolio just as the creation of automobiles began to flourish, as were technology stocks from 2007-18 as the internet and mobile computing took hold “while financials declined amidst a financial crisis followed by heightened regulation”, Mr Meredith points out.
Understanding how the innovation from a technology revolution changes societal behaviour is central to comprehending how a technological revolution might impact value investing. To do this, Mr Meredith makes an example of the mass adoption of the internet, which started with the microprocessor back in 1971, but was made more possible by a wave of technological innovation over the past 50 years.
Amazon (US:AMZN) was the early winner from the internet boom, as the leader in ecommerce, but the introduction of 3G wireless networks in 1998 facilitated the development of the smartphone and eventual launch of the iPhone, which “established a new paradigm for how people interacted with their phones, and connected people to the internet”, highlights Mr Meredith. Apple went on to become at one point the most valuable company in the world, and the number one contributor to growth outperforming value between 2007 and 2018.
But there may be some hope for value investing, for several reasons. “Value investing has historically outperformed after we transition from the turning point,” says Mr Meredith, defined as when “financial capital outstrips production capital, producing valuation bubbles”. “Financial capital eventually re-links, re-establishing normal valuations of the real production of companies, but this can take several years,” Mr Meredith says. Smartphone sales finally peaked in 2018, the first year that sales ever declined – is that a sign we have reached market saturation? If so, earnings could begin to slow for many of the stocks that have been priced for high growth.
One key pivoting point in any technology is when the standards are set for how the technology will be deployed across society, argues Mr Meredith, which contributes to widespread adoption by companies and boosts overall economic growth.
That deployment phase is one that we may have already entered. The widespread adoption of smartphones has established the delivery of information to anyone anywhere, and with embedded cookies, canvas fingerprinting and geolocational tracking, the delivery of information on everyone to anyone. “For every one of the previous technological revolutions, there have been winners that have established the standards, accumulated market share and became synonymous with the technology itself.” In today’s world those are the Faang stocks Facebook (US:FB), Amazon (US:AMZN), Apple (US:AAPL), Netflix (US:NFLX) and Alphabet (US:GOOGL).
However, Mr Meredith’s paper was written in a pre-Covid-19 environment. Value stocks may have been buoyed by a fresh wave of fiscal stimulus from central banks, but there is every chance investors could become unstuck by placing too much faith in a recovery that will boost lowly rated stocks in sectors such as energy and financial services, given the unprecedented nature of the economic shock that the pandemic has wrought.
'Value is dead, long live value' can be read at https://www.osam.com/pdfs/research/Value-is-Dead-Long-Live-Value.pdf
