Value stocks have taken a beating over the past decade. This has made value investing a losing strategy for quite some time now. Growth stocks have outperformed year after year while
Made famous by Graham and Buffett, value investing involves using fundamental analysis to buy underpriced stocks. It requires a great deal of patience.
Lately, the current market cycle is testing even the most devoted value investors. But eventually, that patience is going to pay.
What’s caused value to underperform?
Ever since the financial crisis, value stocks have mostly underperformed growth stocks. Record low-interest rates and a loose monetary policy have helped boost overall valuations. However, this caused a drop in premium for value stocks.
The valuation of growth stocks is largely based on future expectations. Low-interest rates lower the cost of waiting. Consequentially, companies will take on more debt to help accelerate growth. Share buybacks have also helped to boost growth stocks. While most value stocks have instead, issued more shares (especially the financial sector).
Large tech companies have led this record bull run. Their popularity and the huge rise in share price have left value stocks in the dust. The FANG group; Facebook, Apple, Netflix, and Google continue to reign supreme. The advances in technology have also created fierce competition and disruption in conventional industries.
Investors have been buying high and selling higher, triggering substantial rotation into growth stocks. The dominance of fast-growing companies and tech giants continues to rise. Making the current market sectors a bit lopsided.
The assets of many growth stocks are intangible. This makes the practicality of book value and other fundamentals unreliable. These factors have caused people to claim that value investing is dead.
The current credit and economic cycle is not typical. Thanks to quantitative easing and ultra-low interest rates, we are in uncharted territory. In this environment, value investing will likely continue to underperform. I must point out that not every value investor is faltering.
Some have learned to adapt their techniques, and have found strategies that work. Overall, value investing has seen better days but declaring its death is premature.
Why value investing is ready for a comeback
The price gap between value and growth is now the widest it’s been in decades. You can imagine it will close eventually, and the bigger it gets, the better the chances of value making a comeback. Growth and earnings forecasts continue to weaken, and stock buybacks will eventually dry up. The appeal of growth stocks will decline, thus sparking the much overdue rotation back into value.
Sky-high valuations of tech companies and investors pouring money into unprofitable businesses
The lackluster recovery of the 2008 recession heavily favored growth. But a healthy reversion to mean will help value investing shine once again. Trade wars and rising inflation also point to a better future for value. A risk-off environment will cause investors to seek out value stocks to provide a margin of safety.
We are just in an extended period of growth outperforming value. Eventually, growth leaders will prove unable to sustain their momentum. Investors will shift to value once they lose faith in the growth giants. Now that the valuation gap has reached extreme levels, it’s beginning to make value stocks too cheap to ignore.
However, with the widespread availability of financial data and company information, they’re usually cheap for a reason. Don’t just buy stocks because they’re cheap, do your research and avoid value traps. A low price-to-book ratio doesn’t always indicate a good buy. Nonetheless, value stocks will typically beat growth over the long term.
It’s difficult to call the turn
It’s impossible to call exactly when the shift to value will happen. However, I am confident in saying that it’s just a matter of when and not if.
The stock market is cyclical. Current indicators and market conditions show we are in the late stages of a bull market. The severe gap between growth and value stocks can be taken as a signal that things will change soon.
The flip-flopping Fed and unpredictable behavior of President Trump make it difficult to forecast what lies ahead. But once we return to more normal financial cycles, value investing will make a major comeback.