By Dylan Ball
After the longest and deepest period of underperformance compared to growth stocks on record, value stocks during the early months of 2016 delivered the best quarterly rally in two years.
Such episodes have historically been associated with subsequent longer-term outperformance of value over growth, raising hopes that a long-awaited value recovery may finally be getting underway and proving that value does not need an improving economic cycle to work.
Last autumn Franklin Templeton observed that value as an investment style was experiencing its worst underperformance compared to growth on record and trading near the largest valuation discount ever. At Templeton, our conviction in value remains strong and we are optimistic that recent market behaviour may mark a turning point in value’s fortunes.
Investor uncertainty reached its highest level on record in the first few months of 2016. Global equity markets have more than doubled from the financial crisis low, but with concerns about China, credit, central bank policies, currencies and commodities all piling up, where do we go from here?
The investment climate today is a cautious one, noticeably bereft of conviction. Yet our conviction in a value discipline has only strengthened. Having lived through a number of these cycles, we believe the current valuations stands out as especially compelling as the spread between the market’s cheapest and most expensive stocks has blown out to historic highs.
Looking back through history, whenever value stocks have gotten this cheap, subsequent long-term returns have been prodigious. From current depressed valuation levels, value stocks have in the past, on average, doubled over the next 12 months, tripled over the next three years, and more than quadrupled five years later. Not that we necessarily expect returns of this magnitude this time around, but based on our six decades of experience investing through various market cycles, we believe the current risk/reward proposition is heavily skewed in favour of long-term value investors.
Investors would have to go back to the height of the Technology, Media and Telecom (TMT) Bubble frenzy in 2000 to find the last time value traded at such an extreme discount.
We believe it was investor greed that propelled growth stocks to such extreme heights back then; today, fear seems to be sustaining the momentum as investors pay up for the perception of safety and stability in an uncertain environment.
During the TMT Bubble episode, all it took to topple tech stocks priced for perfection was a little bit of bad news. Just a little bit of good news may be sufficient today to spark a recovery among value stocks that seem to be pricing in permanent disappointment.
Understandably, many investors are holding out for a stronger value catalyst than “just a little bit of good news”. In past value cycles, rising interest rates corresponded with a clearly strengthening economy. Rising rates didn’t cause the value rebound, they were merely an effect of a stronger economy and building inflationary pressures.
Today, however, global economic growth is moderate, deflationary pressures persist and most major central banks are explicitly easing policy. While the US Federal Reserve is cautiously hiking rates, it is not doing so against a backdrop of overwhelming macro strength.
So how will value recover absent a definitive macroeconomic rebound?
The point is that while value can be pro-cyclically correlated to the economy, this isn’t always the case. We consider the starting point valuation of value stocks to be a far more accurate predictor of future returns than the outlooks for economic growth. Not only that, but starting point valuations are knowable, unlike future economic growth. When it comes to value, today’s valuation starting point is distinctly compelling, in our view.
Our conclusion is that value works over the long term, but you have to be there to benefit. When value recovers it does so abruptly and investors must be positioned accordingly to reap the rewards. This can be difficult because it requires the discipline to buy usually unpopular stocks and the patience to hold onto those stocks in the face of adversity and volatility. We buy on market pessimism, and the market can remain at odds with our portfolios for a considerable stretch.
We believe “value unbound” describes the most compelling opportunity in equity markets today.
Dylan Ball is portfolio manager for the Templeton Global Equity Group at Franklin Templeton
