As an investment style that typically spends most of the time being ‘wrong’ but is then richly rewarded when proven ‘right’, sustained periods of underperformance have proved inherent to the contrarian style since it was pioneered by Benjamin Graham nearly a century ago.
However, we are currently witnessing statistically the longest period of cumulative underperformance since at least the 1950s, with value lagging its growth style counterpart across all regions since the global financial crisis.
The well-documented drivers of value’s pain have been exacerbated by the coronavirus pandemic. Value investors who had bought into the notion of a ‘margin of safety’ were caught off guard when the March sell-off exposed a lack of downside protection.
Since then, the crisis has further boosted growth-orientated sectors of the market, such as healthcare and technology.
While we recognise the structural challenges for the value style, we do not believe it is time to declare the death of value investing.
We continue to believe there is a longer-term strategic case for holding active value managers.
Investors have increasingly given up on the value style over past years, leading to value funds being starved of assets or closing down.
This has led to more assets chasing growth and fewer focusing on value, which, in combination with other factors, has widened the gap between the relative valuations of growth and value styles to historical extremes.
Looking back through history, buying value during periods of significantly lower valuations has tended to bring with it higher returns in the subsequent periods.
It is very difficult to predict when one investment style might outperform the other and so attempting to time when to be exposed to value is unlikely to capture the factor premia effectively.
For example, over the space of only a few trading days in May we saw a huge value rally that recovered multiple months’ worth of losses. This scenario is typical of the tendency for sudden, unpredictable and aggressive rotations into value.
However, potential near-term catalysts in the market for value outperformance can be identified to offer up some clues. Firstly, the outlook for inflation and economic growth is likely to be a key influencing factor for value, and there is reason for cautious optimism here.
Since the market lows of the coronavirus crisis, we have seen economic activity back on an upward trajectory and indications that market inflation expectations are recovering.
A change in investor sentiment towards leading stocks, such as the Faangs in the US, could lead to an aggressive market correction of not only the top winners but also a re-basing of valuations for growth names more broadly, providing a second catalyst for value outperformance.
The approaches that value managers have taken to respond to their style’s underperformance fall into three different groups.
The first group are ‘deep value’ managers who have become more entrenched in their value bias almost irrespective of its structural challenges, for example increasing their exposure to areas like financials and energy.
The second group have shown style drift towards growth, which is generally commercially driven and evidenced in a high-level shift in the proportion of assets away from value funds and towards core and growth funds recently.
The final group remain with their core value philosophy but incrementally evolve their process to navigate the changing investment landscape. They look at valuation metrics as well as measures of business quality, such as balance sheet strength and free cash flow.
Given the headwinds faced by the style, we believe that effective manager selection is critical when allocating capital to value. We prefer allocating to this last group of ‘core value’ managers, due to their attractively discounted portfolios and importantly, the defensiveness they offer against the risks of the style while also capturing the value upside.
Blending value with other styles in a diversified portfolio offers a compelling strategic case for rewarding investors over the long term.
Oliver Jarman is an analyst at Fidelity International
