When Will Value Come Back Into Favor?
We believe most investors are best served by sticking with an investment style throughout an entire market cycle. A given style may be inherently biased toward one part of a cycle. Understanding that fact can help investors stay the course when faced with superficially inferior results during an unfavorable portion of the cycle.
Recent data suggests the U.S. is favorably positioned to experience continued economic growth and development. If so, this strength should be reflected in a positive ISM Purchasing Managers Index, which in turn could support outperformance by value managers as investors become more comfortable embracing risk.
Behavior of the Average Investor
The average investor will pay more for a stock when he or she perceives it to offer downside protection or a growing stream of earnings. What’s more, the average investor will pay even more if those attractive qualities seem to be scarce - such as during economic contraction.
During periods of market concern, this average behavior (“normalized” in statistical terms) results in higher prices for companies with these attractive qualities. That makes these stocks less attractive to value investors, due to concerns about overvaluation. On the other hand, some investors don’t focus much on valuations: therefore, during uncertain times, they have the wind at their backs.
But the wind shifts when the average investor becomes more optimistic and thereby willing to take on greater risk exposure and buy companies with less certain, though perhaps greater, potential outcomes. Now, value investors have an advantage. Their focus on cheaper companies can be more rewarding as the average investor deploys more capital.
Here’s an important point: expansions tend to last longer than contractions. Therefore, over the long run, value investors should have an advantage. That’s one reason why value has outperformed growth in the long term.
Correlation with Economic Outlook
Here’s market data that shows these ideas in practice. We divided stocks into five groups and compared the return differentials between the “outermost” groups (that is, high-value and low-value stocks) versus changes in the ISM Manufacturing Purchasing Managers’ Index. Since April 30, 2009, 65% of the return differential between high-value and low-value (or growth) stocks has been driven by changes in the ISM Manufacturing PMI.
That is, style rotation (investors’ disfavor with value stocks, in this case), appears to relate primarily to economic expectations.
More details on our research: We grouped stocks within a universe* into quintiles, where Q1 represents securities with the lowest P/E, P/B, and P/S ratios (that is, value stocks) and Q5 represents those with the highest ratios (the growth stocks). We compared their performance to the ISM Manufacturing Index. The solid line depicts trailing 12-month returns of Q1 less trailing 12-month returns of Q5. When it is above zero, value stocks are outperforming growth, and vice versa. The shaded area is trailing 12-month changes in the ISM Manufacturers Purchasing Managers' Index (ISM Manufacturers PMI).
Disclosure:
Past performance does not guarantee future results.
The statements and opinions expressed in this article are those of the author. Any discussion of investments and investment strategies represents the portfolio managers’ views when presented, and are subject to change without notice.
Economic predictions are based on estimates and are subject to change.
Information included from Dr. G. Kevin Spellman, CFA, utilizes data sourced from the FactSet Fundamentals global database and Bloomberg L.P. from 11/30/1994 through 4/30/2014. Statistical tests were run in FactSet Alpha Testing software. Data universe consists of U.S. equity securities greater than $200 million resulting in a total of 693,736 possible. Stocks were grouped into five quintiles based on different degrees of value determined by an equal weighted composite of price-to-earnings, price-to-book, and price-to-sales and rebalanced monthly. Each valuation factor was converted to a percentile before the composite was created. To eliminate sector bias, quintiles were computed for each security with respect to its FactSet sector classification. Outliers that were more than four standard deviations from the mean were removed.
Data Sourced from FactSet: Copyright 2014 FactSet Research Systems, Inc., FactSet Fundamentals. All rights reserved.
The ISM Manufacturing PMI (Purchasing Managers Index) is an index based on surveys of more than 300 manufacturing firms by the Institute for Supply Management (ISM). The PMI index is an indicator of the economic health of the manufacturing sector based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment. A reading under 50 represents a contraction, while a reading at 50 represents no change.
CFA is a trademark owned by the CFA Institute.
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