Neuberger Berman
August 24, 2016
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Value Comeback, or Growth Re-assessment?

After six years of underperformance value stocks appear to have made a comeback since mid-2015. However, it remains unclear how much of this is due to a genuine rotation into value, as opposed to a rotation out of growth and into defensive quality.

The years since the financial crisis have been relatively difficult for value investors. Previous academic research had showed that investing in low-valuation stocks has generally outperformed investing in high-valuation stocks over the long-term even though higher-valuation companies were expected to grow earnings at a faster rate. 1 The thesis was that growth investors generally overpaid for earnings optimism whereas value investors were able to acquire discounted equity overlooked by other investors.

An Interrupted Value Cycle

Looking over the last 40 years, as we do in figure 1, aside from a brief period in 1987 and the late-90s tech boom it is clear that value outperformed growth for the first 30 years but has lagged for most of the last 10. The average one-year outperformance by global large-cap value before 2006 was 276 basis points; since 2006 it has underperformed by 204 basis points. For three-year rolling periods, it has dropped from 977 basis points of outperformance to 364 basis points of underperformance.

1. Value Has Underperformed During the Post-Crisis Period

Rolling Three-Year Outperformance of Value Index Over Growth Index

Source: MSCI. Data as at 30 June, 2016. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

A quick recovery from the bottom of the financial crisis was consistent with past value cycles (as illustrated in figure 2), but since then the normal cycle in value stocks has been interrupted, first by the crisis in the Eurozone and then by the economic slowdown in the emerging world.

As a result, the current cycle has so far skipped the period of meaningful value outperformance that one would have anticipated after a recession, an environment usually characterized by strong growth and improving earnings. Instead, the equity market entered a period that looks similar to the momentum-focused late stages of an economic cycle. This can be seen in figure 3, which shows the deviation of the top quintile of the U.S. equity market by valuation, relative to the average: February 2016 saw a spike in this concentration of over-valuation that would usually be associated with a recession, a hunt for quality growth stocks—and subsequent outperformance by value.

2. For the Past 50 Years, Value Cycles Have Closely Tracked Macroeconomic Cycles

Source: Neuberger Berman. For illustrative purposes only

3. During Q1 2016, Valuation Spreads Reached Extreme Levels Historically Associated With Recessions

Valuation of the Top Quintile of the Equity Market Compared to the Market Average Valuation

Source: Empirical Research Partners analysis, National Bureau of Economic Research. Data as of April 30, 2016.

Although unusual, the prolonged underperformance of value since the financial crisis is understandable. Historically, growth stocks have generally excelled when the economic growth is weak or negative and value stocks have excelled when economic activity is expanding. Stated differently, investors are more willing to pay a premium multiple for companies that are expected to deliver earnings growth when overall economic growth is weak.

Because the six years since 2009 have been accompanied by persistent concerns about slowing global growth, the popularity of growth stocks makes sense. The bias for growth appears to have culminated in 2015 when global oil prices, and energy and basic materials stocks plummeted on fears of another earnings recession. Investors crowded into the biotech and technology sectors and outperformance was concentrated in the headline-grabbing “FANGs” of the large-cap indices—Facebook, Amazon, Netflix and Google.

Is the Tide Finally Starting to Turn?

However, the charts in figure 4 show that sentiment turned again during 2015. Across all regional markets and in both large- and small-caps, value has been clawing back some of its underperformance. During the first half of 2016 value actually outperformed growth in the Russell 1000, 2000 and 3,000 benchmark indices.

Are we finally seeing the market price-in an end to several years of growth doldrums and earnings recession? And are the catalysts required to realize the value in the markets—an improving economy and rising interest rates—falling into place? If so, we may see investors begin to rotate away from sectors such as healthcare, technology and utilities and into late-cycle industrial, energy and basic materials stocks to be positioned for a potential recovery.

4. Value Has Been Reviving Since Mid-2015…

Rolling One-Year Outperformance of Value Index Over Growth Index

Source: MSCI. Data as at 30 June, 2016. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

…Across All Markets

Rolling One-Year Outperformance of Value Index Over Growth Index

Source: MSCI. Data as at 30 June, 2016. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

Rolling One-Year Outperformance of Small-Cap Value Index Over Growth Index

Source: FTSE Russell. Data as of 30 June, 2016. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

It may be a little early to make that call. That “outperformance” by value stocks, especially into 2016, may be driven primarily by markets casting a suddenly skeptical eye over some growth stocks’ inflated valuations and optimistic earnings projections, rather than a rush of confidence in cyclicals.

Several bellwether technology companies failed to meet already very conservative earnings expectations during the first quarter and by June the “FANGS” were down around 5% for the year despite the broader market having climbed its way back within touching distance of its record high. Additional signs of investors balking at unrealistic growth projections can be seen among those $1 billion-plus “unicorn” businesses that have recently gone public at valuations lower than those from their final round of private capital raising.

It’s important to acknowledge “thematic” headwinds that affect some technology businesses more than others, such as the shift to cloud computing, the decline of the PC, the maturing mobile phone market, or the political risks associated with some parts of biotech. Nonetheless, it’s clear that the recent rotation out of growth has been primarily driven by concerns about these companies’ earnings, and that sits awkwardly with the idea that more broad-based growth in earnings is eroding the premium investors are prepared to pay for them.

An Appetite for Quality and Yield Rather than Value

As for the value side of the equation, it is difficult to draw longer-term conclusions about the recent bounce in the energy, natural resources and financial sectors, coming as it did from such a low, oversold base in mid-February.

Furthermore, at the peak of market volatility during the first quarter almost every sector was undervalued relative to its long-term history, as figure 5 shows. Since then, the blue and grey bars show that commodities and capital-equipment stocks have been substantially re-rated and that pharma and biotech have gone out of favour. However, the lack of movement for energy and financials and the rising valuations in consumer staples and utilities do little to support the argument that the economy is entering a broad expansion to boost cyclical value.

5. While Some Sectors Were As Cheap As They Have Ever Been In Q1, the Value Opportunity Was Broad-Based

U.S. Equity Intra-Sectoral Valuation Spreads, Current Readings Compared to History Since 1950, Percentiles (1%=Narrowest, 100%=Widest)

Source: Empirical Research Partners analysis. Based on a 1,500-stock universe. Valuation framework varies across sectors depending on which measure is most efficacious: free cash flow yield is used for the software, hardware, pharmaceutical and biotech, and equipment and services sectors. Data for the pharmaceutical and biotech sectors is based on valuations since 2000.

Indeed, the appetite for consumer staples and utilities reflects the persistent hunt for high-quality, rather than explosively-growing, earnings. In the turmoil of the first quarter, these sectors also became attractive for investors searching for alternative sources of yield.

We also see conservatism if we look deeper into financials. Here, investors may have turned pessimistic on regional banks’ ability to increase their net interest margins as the Fed delays its interest rate hikes, whereas REITS yields have appealed for the same reasons.

To summarize, while a glance at some charts suggests that value stocks are making a comeback after years of underperformance, some of the relative gains appear due to a re-assessment of stretched valuations in certain growth sectors. While there is ongoing appetite for yield-oriented sectors, that seems to have more to do with lower-for-longer rates expectations than with a rotation into deep value. The concurrent bid for quality reinforces that impression.

Something may well be stirring in the markets, and it would be dangerous to assume that the relative performance of value stocks will never revert to the mean. For now, however, it feels as though the place to be is “quality” or “intrinsic” value as opposed to the more economically-sensitive, cyclical variety.

1 For example, see Sanjoy Basu, “Investment Performance of Common Stocks in Relation to Their Price-Earnings ratios: A Test of the Efficient Market Hypothesis”, Journal of Finance 32.3 (June 1977); Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns”, Journal of Finance 47.2 (June 1992).

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