Maintaining focus: Value's strong fundamentals

John Goetz

Pzena Investment Management

The opportunity in value stocks remains compelling. Long-term investors should ignore the noise and focus on cheap valuations, strong operating metrics, and the solid real returns value stocks offer

Focus on the value opportunity

We have argued for some time that the opportunity in value stocks is compelling: valuations are cheap, operating metrics are strong, and they offer high single-digit to low double-digit real returns, depending on geography.

Despite value’s fantastic fundamentals, it has seen uneven performance among the ebbs and flows of macroeconomic uncertainties.

Given the severe downturn in economic activity that occurred at the outset of the pandemic, it should not be surprising that economic recovery is coming in fits and starts.

We believe long-term investors should be rewarded over a long and enduring pro-value cycle if they look past these temporary setbacks, ultimately benefitting from the fundamentals that remain in place.

Positive real earnings yield for value

Value stocks are one of the few investment opportunities offering positive projected real returns, where the earnings yield is well in excess of expected inflation.

The earnings yield of cheap stocks, or the price one pays for normalized earnings, ranges from low double digits to mid-teens across the world.

Alternatively, investors have bid up the price on global fixed income products to the point where there is little yield to be earned on “safe” assets (Figure 1).

Meanwhile, expensive stocks have continued to get more expensive. Today the market cap of stocks that are trading at greater than 10x sales is more than twice what it was in the internet bubble and three times the market cap of the cheapest quintile (Figure 2).

Value cycles are bumpy

Contributing to the compelling valuation disparity, June 2021 was one of the worst months for value, as the Russell 1000 Value Index trailed the Russell 1000 Growth Index by 7.4 percentage points (one of only 17 months over the past 42 years in which value trailed growth by more than 5 percentage points). And as value trailed again in July and August, investors wondered if the value rally was over.

The anti-value period in markets that has lasted for much of the last decade is a potent reminder of the cyclical nature of value.

However, it is such periods, during which the majority of investors give up on cheap stocks, that create the conditions for the strategy to work over the long term.

While value has outperformed the broader market by 320 basis points per year on average over the last 50+ years, it hasn’t happened in a straight line.

In fact, even during powerful value cycles, there are numerous shorter periods in which value underperforms the market (Figure 3).

Over the past 42 years, the Russell 1000 Value Index has outperformed the Russell 1000 Growth in 51% of all months. Interestingly, during pro-value cycles, or periods when value dominates growth, this only improves to 56% (Figure 4).

Over the past 42 years, the Russell 1000 Value Index has outperformed the Russell 1000 Growth in 51% of all months. Interestingly, during pro-value cycles, or periods when value dominates growth, this only improves to 56% (Figure 4).

Even among the 17 most extreme months of value underperformance, eight of them occurred during pro-value cycles, and four of those happened during the first 20 months of the post-Tech Bubble period, which was one the greatest value cycles on record.

That cycle lasted more than seven years. Investors who clung to growth stocks, failing to appreciate that the cycle had turned, on average missed out on more than 87 percentage points of value outperformance versus the market, or about half the value outperformance for the entire cycle.

Strong operating metrics

Low multiples and long cycles are great, but at the end of the day, an investor is buying shares of businesses, and ideally good businesses.

One typical criticism of cheap stocks is the myth that they are low quality. When taken in aggregate, the profile of cheap stocks is quite different.

The stocks currently in the cheapest quintile have generated a historical average return on equity (ROE) in the low- to mid-teens across the US and non-US geographies.

Additionally, these stocks have historically grown the top line at mid-single digits, proving a fruitful hunting ground for the active value investor (Figure 5).

Powerful earnings growth at a significant discount

Value stocks were hit particularly hard, as the world went into lockdown in 2020. As stocks recover from COVID-19, Wall Street analysts are projecting earnings of value stocks to grow at more than a 20% compound annual growth rate (Figure 6).

We believe supply chain disruptions and the Delta variant of COVID-19 will not negate an eventual full economic recovery, though could lead to a more protracted one, which should extend the associated outperformance of value stocks.

The cheapest stocks are projected to grow slightly faster than growth stocks the next few years, while trading at a roughly 60% discount (Figure 7).

Maintain focus

Pro-value cycles have never happened in a straight line, and the current cycle is no different. Supply chain disruptions and COVID-19 variants may impact the timing of the recovery, but value stocks should continue to see earnings recover at a more rapid pace than the rest of the market over the next couple of years, as the economic recovery continues to take hold.

We believe the ability to purchase high-quality companies at low-teens earnings yields is what enduring value cycles are made of.

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John Goetz
Managing Principal, Co-Chief Investment Officer
Pzena Investment Management

John is a co-portfolio manager for the Global, International, European, and Japan Focused Value strategies.

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