Is the ‘great rotation’ to value stocks underway?

Value investing involves aiming to buy shares that are cheap in relation to their earnings or assets.

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  1. Rob Morgan

‘Value’ investors have suffered poor returns in recent years, with the trend of outperformance for growth stocks, e-commerce and other technology companies further accelerating over 2020. Value investing involves aiming to buy shares that are cheap in relation to their earnings or assets, and places emphasis on measuring a companies earnings or assets in relation to its price.

Although it makes sense to buy into companies below ‘fair value’, the performance of funds adopting this approach has been underwhelming. The chart below shows the performance of global stock markets in the developed world split into two halves: value and growth. Value has lagged a long way behind over the past decade.

Chart: Global value stocks (blue) and global growth stocks (red) over the past ten years

Source: FE Analytics, data to 19/11/20. Past performance is not a reliable guide to future returns.

Recently, though, long-suffering value investors have been given fresh hope of a 'great rotation' in their favour. The outcome of the US election and positive news about a potential Covid-19 vaccine has had a dramatic effect, spurring a rotation out of technology and other stocks deemed to benefit from a ‘lockdown’ world and into areas expected to capitalise on a speedier return to normal life and better economic growth. It’s only a blip on the blue line in the chart above, but could it have wider significance and herald the start of a new chapter in markets?

Some commentators expect economically sensitive value stocks to emerge as winners from the forthcoming Biden presidency. Economic stimulus in the form of commitments to renewable energy and infrastructure might mean certain construction and utilities companies do well. Biden proposed a $1.7trn policy aimed at making the US carbon neutral by 2050 during his campaign as well as a $1.3trn infrastructure improvement plan.

A positive resolution to the pandemic and sustained economic recovery would also favour value stocks, many of which are tied closely to economic growth, either globally or regionally, as well as smaller companies whose fortunes are more often predicated on the success of their respective local economies. Much therefore depends on whether the efficacy of vaccines lives up to their promises and, logistically, how quickly they can be rolled out. Recent market action could be just a taster of what is possible from the cohorts of under-owned and unloved stocks that investors were quick to abandon in an increasingly digitally driven lockdown world, albeit disappointments could easily see the trend reversed.

A growth-to-value switch might be further propelled by the all-important technology sector encountering headwinds. For instance, president-elect Biden might be tempted to break up monopolies in e-commerce and social media, limit the influence of tech giants on society or impose taxes. Perhaps the biggest obstacle for tech and growth stocks, though, could be a return of higher inflation and expectations of higher interest rates as growth stocks’ lofty valuations are partly a function of super-low bond yields.

There have been several false dawns for value investing over the past few years, and its important to bear in mind that growth was firmly in the ascendency before the pandemic hit. Therefore, a return to ‘normality’ might not be as positive for value stocks as a more traditional economic upturn. Shares and sectors which have been badly damaged by the absence of customers during lockdowns and the shortage of turnover can be expected to bounce if as they return to better earnings, cashflow and profitability. Yet some businesses will be forever scarred by smaller volumes or a balance sheet that is in far worse shape, notably those that have burnt through cash reserves and issued equity or debt.

We would therefore suggest that investors looking to increase their exposure to value do so selectively, perhaps with a trusted active manager that can sort the recovery success stories from the permanently disrupted and challenged.

In addition, major long-term structural trends will remain unchanged by Covid. The green revolution will remain a disrupter of carbon-based businesses such as oil and gas production and conventional autos. The pandemic has also accelerated consumer habits towards greater online activity. Many people will retain the remote ways of working, learning, and shopping they have become accustomed to, which means many tech and growth stocks won’t easily be derailed, especially if a low growth and low inflation world is here to stay.

The question therefore shouldn’t be whether value or growth is best, but how to find the best opportunities in each camp to populate a portfolio for the best returns.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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