Stocks with attractive fundamental attributes (attractive valuations, high quality, improving growth expectations) typically outperform the broader market. Recently, however, stocks with the opposite attributes have outperformed. This has been especially true with respect to Value stocks. Expensive stocks with weaker fundamentals have delivered substantially better performance than stocks with much more attractive fundamentals and valuations. This dynamic has resulted in historically weak performance for Value factors in recent years.
QMA believes the current market environment is poised to generate some of the best returns for Value in a quarter-century. The magnitude of both cheap stocks’ underperformance and the outperformance of expensive stocks (in particular, fundamentally weak expensive stocks) is, from QMA’s perspective, an irrational overreaction. Historically, overreactions like this have led to massive corrections. Following the Tech Bubble and Global Financial Crisis (GFC), corrections were in excess of +30% for Value.
In a recent research paper, QMA explains why it expects Value outperformance to follow the current period of underperformance as valuations revert to more normal levels. Among other catalysts, QMA believes that macro changes--such as global growth, recession, policy stability, and regulations that foster competition--could contribute to a rebound in Value.
Not a Value Trap
Value traps are normally accompanied by significant declines in fundamentals (i.e., they are cheap for a reason). In the past, fundamentals have somewhat deteriorated, but prices expected a bigger deterioration, so the bounce-back more than offset the fundamental deterioration. In a value trap environment, investors would expect a greater deterioration in fundamentals. But in the last 18 months, there has actually been an improvement in fundamental earnings for Value stocks, but a deterioration in pricing, leading to meaningful multiple contraction. This combination is unprecedented, and signals the opposite of a value trap environment.
So, what’s driving Value’s underperformance? While recent earnings have held up better than they did in the past, the market has been less willing to reward them as investors are concerned about the sustainability, quality, or riskiness of the earnings. When EPS growth is positive, which is actually quite rare for cheap stocks, and multiples are contracting, all signs point to elevated risk concerns and an overreaction by the market.
A Growing Value Opportunity
While markets today do not feel as frothy as the Tech Bubble, nor as overwhelmed with systematic concerns as in the GFC, the relative dislocations today are comparable with both episodes. The current episode of Value weakness is more broadly based than the Tech Bubble or GFC, in which Value weakness was largely concentrated within the Technology and Financials sectors. Since the beginning of 2017 through mid-August of this year, the Russell 1000 Value Index underperformed the Russell 1000 Growth Index by a cumulative -38%, a magnitude not seen since the Tech Bubble. At the height of the Tech Bubble, the return differential between the Russell 1000 Value Index and the Russell 1000 Growth Index was -17% in 1998 and -19% in 1999. But performance completely reversed over the following three years, as the bubble imploded. The return differential between the Russell 1000 Value Index and the Russell 1000 Growth Index was +38% in 2000, +19 in 2001, and +17 in 2002.1
Such dislocations indicate extraordinary investment opportunities ahead. The wide differences in the current valuation spreads (measured by earnings yield) of cheap and expensive stocks suggest that stock prices have significantly deviated from fundamentals. The implication is that the expected returns to Value are meaningfully above average. Historically, there have been significant returns to Value once dislocations correct in the market.
To confirm its view that there is growing opportunity for Value stocks, QMA examined the behavior of corporate insiders, as they are in a unique position to gauge the current and future fundamental strength of their companies. They found that more buying is occurring in cheaper stocks relative to their more expensive peers. In fact, they saw that the correlation between corporate insider activity and earnings yield is at the strongest rate since 2010, suggesting that corporate insiders also agree that there are meaningful Value opportunities available.
Correlation Between Corporate Insider Activity and Stock Valuation
Source: QMA, FactSet, Washington Service. As of 6/30/2019.
Chart shows the correlation between insider trading activity and forward earnings yield from May 2010-June 2019, and illustrates that the current correlation is well above the historical average.
Three Catalysts for a Value Rebound
Among other possibilities, QMA believes that the following catalysts could contribute to a rebound in Value.
1. Less policy uncertainty
This would reduce concerns stemming from trade-related issues and investor aversion to cheaper economically sensitive stocks. Reduced policy uncertainty would also give corporations more confidence to invest in R&D/CAPEX, contributing to a reduction of takeover sentiment in the market.
2. A sustained reacceleration of global growth or a full-blown recession
Acceleration of global growth would contribute to investors’ preferences likely shifting toward cheaper economically sensitive stocks. Scarce Growth stocks would likely suffer as growth becomes more abundant. With accelerating growth, conditions would also be more favorable for a normalization of interest rates (i.e., the favorable monetary conditions for Growth stocks would weaken). Alternately, a full-blown recession would likely bring about a reality check in Growth stocks. Cheap, economically sensitive stocks are largely priced for an expected recession. As such, an actual recession would likely have less impact on cheap stocks.
3. Regulations that foster competition
Regulations would contribute to the market realization that the growth of disruptive innovators is not sustainable; they have been benefiting from monopolistic conditions. Regulations would likely change sentiment to the broader space of disruptive innovators, allowing investors to realize traditional businesses are not facing an existential threat. A rebound in Value could also stem from something as simple as a single Growth stock having a significant earnings miss, leading investors to reevaluate the whole space (e.g., Netflix). It could also occur as investors finally acknowledge and begin to trust the earnings yield differential.
With Value performance at extreme levels, the resulting market dislocations arguably represent the biggest investment opportunities of the last decade—if not the last 25 years. However, it’s unwise to speculate on the timing of any potential catalysts. As timing Value can be a costly endeavor, QMA thinks it’s wiser to recognize that there are significant dislocations and position for a correction. QMA’s processes naturally increase the tilt to Value in conditions like those we are currently experiencing. QMA seeks to gain more on the upswings than downturns. Investors who share QMA’s view may want to consider adding their own Value tilt at a total portfolio level.
Read the full paper, Value vs. Growth: The New Bubble, which is available for financial professionals, for more details.
1Source: QMA, FTSE Russell as of August 2019.
The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
The views expressed herein are those of QMA at the time the comments were made and may not be reflective of its current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. This commentary does not purport to provide any legal, tax, or accounting advice. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. Each manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy.
Certain information contained herein may constitute “forward-looking statements” (including observations about markets and industry and regulatory trends as of the original date of this document). Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. As a result, you should not rely on such forward-looking statements in making any decisions. No representation or warranty is made as to future performance or such forward-looking statements.
1027217-00001-00 Ed 10/2019