Why value investors should hold the line

Coronavirus-spurred trough in business cycle could lay groundwork for revival of beaten-down factor

Why value investors should hold the line

To put a twist on an old maxim: the deeper the fall, the bigger the bounce – or at least, that’s according to one outlook on value stocks.

In a newly published blog post, Pail Eitelman, director and senior investment strategist at Russell Investments, noted that value stocks’ years-long record of underperformance only got worse in the first quarter of 2020.

“For example, looking across large capitalization U.S. equities, our proprietary value factor portfolio is trading at a 56% discount to the market on a sales-price basis,” he said, noting that outside the Great Depression, that valuation spread was matched only by the tech-bubble environment of 2000. “[T]he potential return opportunity in a value-oriented equity strategy might be much larger than normal today.”

One feature of value stocks that may make an allocation to them apt for today’s environment, he said, is the fact that their long-term premium compensates investors for the risk of black swan events, including rare diseases such as COVID-19. Ongoing re-openings in regions such as China, Germany, Texas, and California indicate that the world’s past the nadir of the coronavirus-induced economic crisis, which would mean a potential resurgence for value strategies.

“In the United States, value stocks have, on average, outperformed by 730 basis points in the 12 months following a trough in the business cycle,” Eitelman said.

Another factor favouring value stocks, he said, is the modestly higher levels of leverage in their balance sheets relative to the broad equity market. Against the Federal Reserve’s aggressive steps to support the functioning of the U.S. corporate-bond market, Russell Investments’ fixed-income analysts expect a compression in spreads between investment-grade and high-yield credit spreads in the next 12 months.

“Our research suggests that value stocks, on average, have outperformed by 1,600 basis points in periods of falling credit spreads,” he said, adding that support measures by the U.S. federal government should help backstop against severe credit events.

Finally, he pointed to a contrast between value and growth stocks, particularly how value tends to have a shorter duration profile to their cash flows when compared to growth companies. That discrepancy creates distinct performance patterns in equity styles that respond to movements in the U.S. Treasury yield curve, which Eitelman said is more likely than not to bear-steepen as investor risk appetite normalizes further and the global economy gradually recovers.

“We find that in 12-month periods in which yield curves are steepening, value stocks on average outperform by 330 basis points,” he said.


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