By: Case Eichenberger, CIMA®, Senior Client Portfolio Manager
In this week’s Making the Case, I address value stocks. Particularly, U.S. value stocks. Value stocks trade at a discount relative to the market, but occasionally they trade at very deep discounts. Investors typically expect to be compensated for the extra risk with these stocks, which tend not to be ‘popular’ stocks.
Currently, value stocks have underperformed the market as well as expensive growth stocks. In this blog, I review how long you may need to wait, how CLS looks at value, and what the future may hold. Enjoy!
Value: How Long Should We Wait?
Larry Swedroe, of the BAM Alliance, has written some great blog posts and research lately that gives insight into the reasons to invest in value and why the premium they deliver is not guaranteed but still exists.
Below we’ve highlighted some of the data Swedroe outlined in a recent article. He shows that value stocks, over a 10-year period, have a 14% chance of underperforming the market and growth stocks.
What insights can we glean from this? As with all risks, nothing is guaranteed. That is why it is called risk. But over time, the value factor has provided excess returns over the market.
Do you believe that stocks add value over bonds in the long term? Sure, that is often the case. But, as the data above shows, there is a 9% chance that over a 10-year period, stocks (beta) will underperform bonds. This happened recently from 2000 to 2009. Value stocks are no different.
One must be patient to reap the rewards of market performance. As CLS is tilting toward value currently (for reasons below), we preach patience.
Value: What is CLS’s Approach?
CLS is not like some investment managers that only invest in value stocks. At times, value stocks can become expensive relative to growth, and that would indicate that future returns may be lower. From 2000 to 2007, value stocks did very well against the broad market. But once they outperform, they become expensive, making them due to underperform. Sound familiar? This is what’s happening now.
CLS seeks to smooth this out by using a relative value approach to investing. Sometimes, growth stocks are cheap, and we will tilt toward them.
The first chart below shows that in late 2011/early 2012, growth stocks became cheap.
Lately, however, growth stocks have become expensive and value stocks cheap. So, what will CLS do? We will buy what’s on sale.
As shown below, value stocks are trading at discounts relative to growth not seen since the tech bubble! As a prudent risk manager, we will buy what is undervalued (second chart).
Relative value investing means finding assets that are on sale compared to their normal levels and compared to another market. Right now, value stocks hold both characteristics, and we believe they look attractive for future returns.
Value: Where Do We Go From Here?
To help investors stay patient while value goes through this cycle of underperformance, it’s helpful to quantify the long-term value of value. CLS Director of Research and Senior Portfolio Manager Grant Engelbart did just that recently and found that returns for one year, three years, five years, and 10 years into the future will likely reward investors for staying patient and not chasing returns.
When value stocks underperform growth stocks by more than 5% on an annualized five-year basis, future returns are higher. Much higher.
See charts below. Source: Morningstar.
If you are interested in reading more, please check out these resources. Links below.
Thank you for reading.