Value’s Big Surge – Has It Gone Too Far?

You may remember us writing about “The Return to Value” in our December 2020 Wealth Watch. In that edition, we mentioned the developing rotation from high-flying growth stocks to value companies. That trend continues today in strong fashion. The question is, can it last? History suggests it certainly can.

The Value Premium

You hear us talk about the value premium quite often. There is pervasive evidence that value (cheap) stocks outperform growth (expensive) stocks over time. According to Dimensional Fund Advisors (“DFA”): “data covering nearly a century in the US, and nearly five decades of market data outside the US, support the notion that value stocks—those with lower relative prices—have higher expected returns.” Essentially, if you pay less for one stock vs. another, you win over time.

Therefore, it seems obvious. Tilt the portfolio toward value and reap the reward. Unfortunately, there is no free lunch. To capture this premium, investors must endure some level of tracking error. Or, in other words, periods of underperformance.

The first nine-months of 2020 were a perfect example, as value companies were hit extremely hard by the pandemic. Airlines, hospitality, retail and particularly energy suffered tremendously as people began staying home and individuals and businesses turned to online communication and shopping platforms.

As the prospects for a post-coronavirus world improved, we have seen that trend reverse. Value companies, particularly small value as represented by the Russell 2000 Value Index, have significantly outperformed:

Source: Ycharts – Data from 10/1/2020-3/17/2021

We should not be surprised by this, as valuations eventually matter. Value stocks were at the cheapest level relative to growth since the Great Recession:

Source: JP Morgan 12/31/1997 through 12/31/2020

Note the shaded areas that represent past recessions. Value performed quite well after these periods.

Pandemic Plays

Companies that emerged as winners during the crises like Netflix, Zoom, and Amazon significantly outperformed the first nine months of 2020:

Source: Ycharts – Data from 12/31/2019-10/01/2020

Investors tend to extrapolate the past, however, and the following underscores the importance of diversification. All of these companies posted negative returns since 10/1/2020 and significantly lagged the growth index, which has in turn lagged value indexes:

Source: Ycharts – Data from 10/1/2020-3/17/2021

The Biggest Names Underperform

What about other big names besides Amazon, such as Apple, Microsoft and Facebook? Only Microsoft slightly outpaced the growth index since 10/1/2020. The rest have underperformed.

Source: Ycharts – Data from 10/1/2020-3/17/2021

History suggests this trend could continue. According to DFA, from 1927 to 2019, the average annualized three-year return for stocks before joining the Top Ten in size was nearly 25% higher than the market. Five years after joining the Top Ten, they underperformed the market on average. That gap was even wider ten-years out.

Source: Dimensional Fund Advisors

Conclusion
Some investors argue that today’s growth stocks are less risky because many are profitable with strong balance sheets. But even if a company has strong fundamentals, it is not bulletproof, especially if valuations are stretched. It can underperform for a long time if the expected earnings (or higher interest rates in today’s recent market) can’t support the valuations. An investment in Microsoft in late March 2000, one of the strongest companies coming out of the tech bubble, took nearly 14 years to recoup:

Source: Y Charts 3/30/00-3/1/2014

If history is any indicator, the economic recovery should continue to broaden beyond growth companies. Value, while having surged as of late, long-term evidence supports it may still have a way to go.