Value investors have had a rough time recently. Over the past three years, total returns for value stocks (as measured by the FTSE 350 Top Return Index) have been only 4%, compared to 32% for the Underperform Index. High-value stocks did even worse; my top 20 yield portfolio fell almost 30 percent in terms of price during that time.
The past three years, however, have only continued a longer-term trend. Over the past 20 years, the high yielding FTSE 350 index has underperformed its low yielding counterpart by 1.4 percentage points per year, even taking into account its higher dividends.
Older readers can be forgiven for being upset by this. For years, the conventional wisdom, inspired by the work of Benjamin Graham in the 1930s and 1940s, was that value stocks were better investments. What they have been for a long time. In a famous 1997 article, Nobel Laureate Eugene Fama and his colleague Ken French pointed out that value stocks have outperformed growth stocks around the world for years.
So what has changed? This could be an example of Murphy’s Law. When investors learn that a type of stock has outperformed in the past, they accumulate. But it pushes these stocks so far that they don’t fare well afterwards – sometimes for many years. What happened to small caps in the 1980s and 1990s has been the fate of value stocks in recent years.
Something else has happened, however, that offers a silver lining for value investors.
My graph shows what. It shows that the long-term underperformance of value stocks has come along with a downtrend in long-term real interest rates. More remarkable still, the exceptions to the trend in real returns also coincided with exceptions to the underperformance of the stock. The few instances of rising real returns – in 2008 and 2021 – also saw the stock outperform. And when real returns moved sideways between 2012 and 2014 and 2017-18, the value versus growth also shifted.
No. There is a simple reason for this link. Growth stocks offer cash flow in the distant future than value stocks: that’s what growth means. Lower bond yields, however, mean investors apply lower discount rates to future cash flows, thereby increasing their present value. As a result, growth stocks outperform value when returns fall. Long-lived assets outperform when long-term returns fall, and growth stocks are longer-lived assets than stocks.
Of course, bond yields aren’t the only influence on the relative performance of growth and value. Value stocks tended to do badly when the All-Share Index and the British Pound fell. Indeed, all three are cyclical assets, which do well in good economic times and badly in bad ones like 2008-2009 or early 2020.
This is where the hope of value investors lies. If or when the long-term downtrend in real returns stops, the stock’s underperformance should also stop.
However, you have to be careful here. The question is: why might real returns increase?
One possibility is that they are doing this as investors anticipate higher short-term real interest rates as central banks tighten monetary policy. What matters here are US and UK interest rates: bond yields are determined by global forces.
In this case, if value stocks outperform, they could only do so by falling less than growth stocks. And they might not even succeed. If investors fear that a tightening of monetary policy will cause serious economic damage, they would be shedding more cyclical value stocks than growth stocks.
The much more attractive possibility for value investors would be that bond yields rise because markets anticipate stronger economic growth. In this scenario, value stocks such as miners and homebuilders would benefit from the greater willingness of investors to take cyclical risk. And they would benefit over growth stocks, as higher yields cause investors to ditch the latter in favor of shorter-lived stocks.
Unfortunately, this prospect is far from guaranteed. The pandemic has done nothing to weaken the long-term causes of secular stagnation. And rising energy and commodity prices, along with a fiscal tightening in the UK, could actually dampen growth next year. So there is a great risk that value investors will experience further disappointment. Your fate as a stock picker depends more than you think on macroeconomic conditions.