These ignored stocks may be poised to rebound
Buying so-called value stocks at bargain-basement prices has netted sub-par returns for more than a decade. The big winners have been popular growth stocks like Alphabet, Amazon and Netflix that keep going up despite selling at much higher valuations.
But don’t count out the market’s diamonds in the rough just yet, Wall Street fund managers and investment strategists say. These ignored stocks could be poised to play catch-up.
Value investing is buying stocks that are trading at low valuations relative to earnings, book value and sales. Buying stocks at lower prices is a good indicator that they’ll deliver higher future returns than more expensive stocks, says Wes Crill, senior researcher and VP at Dimensional Fund Advisors.
“This is one of the best times in history to buy value relative to growth,” adds Dave Iben, chief investment officer at Kopernik Global Investors. “You’re really getting bargains on companies people don’t like. Now is the time to take advantage.”
Value stocks he likes include China Telecom, General Electric (which once was the most valuable company in the U.S. but has fallen on tough times), and natural gas company Range Resources.
“A lot of value stocks are selling at half of what we think they’re worth,” Iben says. “If we’re right," Iben says, "they will double.”
Value stocks can sell at steep discounts for a variety of reasons. They can go on sale because of a short-term business hiccup, a public relations crisis, a CEO change, movements in interest rates, economic slowdowns, or overly pessimistic investors pricing them too low. Value sectors include financials, health care, industrials, and different types of consumer-facing companies.
Part of the current appeal of beaten-down value stocks is that they’re now cheaper compared to their growth counterparts than they’ve been in a very long time. Value stocks, as measured by their price-to-book ratio (i.e. what the company would be worth if liquidated), are trading at their lowest valuations relative to growth in at least 20 years, according to Bank of America (BofA). “Value is inexpensive,” says Jill Carey Hall, an equity strategist at BofA.
The best time to buy value stocks is during a recession, says Andrew Slimmon, managing director and portfolio manager at Morgan Stanley Investment Management. Prices get so “extraordinarily cheap” in bad times that it creates a great buying opportunity. The big money is made when value stocks go from unusually cheap to more normal valuations.
“No one wants to buy industrials, energy stocks, airlines or cruise ships during a recession,” Slimmon says. “But that’s when you make the biggest returns. You can have doubles and triples in many value stocks.”
Another sign of just how much value stocks – such as banks like JPMorgan, communications companies like Verizon and health care plays like Johnson & Johnson – have lagged growth is by comparing performance.
From the end of 2006 to the end of 2019, the latest period in which value has fared worse than growth, the Vanguard Value Index Fund posted a return of 76%, vs. a 215% gain for the Vanguard Growth Index Fund. This year through June 26, despite a brief period of eye-popping returns for value after the recent market bottom, the value index is down 19% and the growth index is up 7.5%.
But just because value stocks are selling at blue-light special prices doesn’t mean they have to go up. To start moving higher, a catalyst or bullish narrative is required. Investors need a reason to shift some of their money into value names that haven’t been performing well and rotate out of market leaders like growth stocks.
Some catalysts that have spurred value stocks higher in the past include:
Recession gives way to recovery
Some of the best stretches of performance for value stocks going back to the 1930s have come when the economy was emerging from recession, BofA data show.
“When profit growth is accelerating and earnings are becoming more abundant, investors don’t need to pay up for expensive growth stocks,” says BofA’s Hall. “That’s when value tends to work well.”
Cheaper valuations become more attractive during rebounds, allowing value stocks to shine. While the current recession due to the shutdown of the economy has been sharp, a gradual recovery is expected as more parts of the economy reopen, economists say. The common theme of the cheapest value stocks screened by Morgan Stanley is that they’re “all exposed to the economy and need the economy to recover,” says Slimmon.
Highfliers come back to earth
Just like the “Nifty Fifty” large-cap stocks that nobody thought could ever go down in the late 1960s and early 70s, or the overloved dot-com stocks that crashed in early 2000, a shift to value stocks can occur when growth stocks get too popular and too expensive, and investors dump them in favor of cheap stocks, says Iben. “People eventually realize that the premium prices that they’re paying have reached a level that is too high even for really good companies,” Iben explains.
Value gets too cheap to ignore
For a long time, there wasn’t enough value in value stocks to buy them. But that changed in the bear market this spring, says Christopher Harvey, head of equity strategy at Wells Fargo Securities. “Prior to the selloff in March, we hadn’t seen value stocks selling (so cheap relative to) book value in 10-plus years,” he says. It makes sense now, he says, for investors to “pepper their portfolio with value names.” He now sees value in credit card companies, chipmakers and tech hardware names, and plays related to housing, such as homebuilders and consumer companies targeting do-it-yourselfers.
Fund managers start buying
Value stocks are currently among the least-owned stocks in funds run by portfolio managers, BofA research shows. If money starts to flow back into actively managed funds in search of value and outsized future returns, those fresh cash inflows can lift the prices of value stocks.
Hall says BofA’s research shows that when particular stocks or parts of the market get too much attention and are inundated with cash from fund managers, like big tech stocks these days, it can signal that everyone has “globbed on” to the same investment idea, setting up a potential rotation into value. “We have seen some early signs in our work tracking fund flows the past few weeks that there have been flows into value ETFs,” Hall says. “We’ll have to see if that persists.”
But not all market pros are buying into the value renaissance. They argue that those same attributes that drove growth stocks to the top of the performance charts will continue. Leading technology stocks, the quintessential growth stocks, for example, benefit from asset-light business models that enable them to retain a bigger portion of growing revenue streams as their market share rises, says Elliott Savage, portfolio manager at YCG Enhanced Fund. Growth companies tied to tech are also better positioned to take advantage of the economy’s shift toward digitization, as opposed to value companies that are more capital intensive.
“There will be a time when value will outperform, but I don’t think it is now,” says Tom Plumb, manager of the Plumb Balanced Fund. “In my experience, being early is like being wrong.”
Low rates, Plumb explains, favors assets like growth stocks. And with the Federal Reserve hinting that its key interest rate will stay near zero through 2022, value will have a tough time outshining growth.
Slimmon disagrees. He says value stocks are “just in the third inning” of a rebound. The recent pullback of value names due to fresh concerns about the reopening of the economy, following a brief yet powerful runup after the market low in March, gives investors a second shot at gaining exposure to value names, he says.
Timing the turn isn’t always easy, adds Crill. That’s why it makes sense to get exposed to value now.
“We don’t know when value will turn positive, but when it does, we don’t want to miss it,” Crill says.