2020 has seen an acceleration of under-performance for value stocks relative to the main indices after ten miserable years. Tech is a clear winner from the COVID pandemic, whereas the losers have in the main been in industries which are typically value. This article looks in more depth at the whether there are any reasons for expecting these trends to change and buying value today.
We start by asking what we mean by value. It certainly should be a broader definition than just looking at tangible assets. That would miss the fact that the world today, at least in the West, is increasingly about providing services rather than making goods. Brands, intellectual property, or human expertise all have a value which may be under-priced by the market.
Growth valuations over the past few years have powered ahead for two reasons. One is investors’ hunger for quality stocks which can deliver predictable long term earnings. That in turn has been driven by the falls in bond yields, in its turn caused by demand for safe assets as collateral for short term corporate lending and the repo markets. Because bond yields are so low, investors look for ‘safe’ substitutes such as equities whose future earnings can be considered assured by the nature of their business. There is an added kicker that low bond yields increase the net present value of the long term earnings stream.
The second reason is the domination by large tech companies of a vast range of the world’s activities. Put bluntly they are eating a lot of other industries’ lunches, and COVID-19 has only accelerated that process. Investors are inevitably attracted.
We are not predicting a sudden change in either of these factors, although we can see a few straws in the wind. We do firmly believe that when a shift happens, it will be when investors fall out of love with growth rather than in love with value. So what might make that come about?
A rise in bond yields is the most obvious answer. We can advance a number of technical reasons why long bond yields should rise, such as the extreme lows in term premia and (from our friends at CrossBorder) that yield curves always steepen when there is liquidity expansion. But the fact is that demand for long bonds has continued to be strong at least until very recently, and even the unprecedented issuance by central banks this year has hardly satiated it.
The straw blowing in the wind here is a possible change in the balance of supply and demand. Does the normalisation of credit markets generally as a result of the Fed.’s actions suggest that there is now adequate supply of safe assets as collateral? And will overseas holders of US T-bonds, and particularly China decide to reduce their holdings as U.S. power wanes? Our slender evidence is the surprising lack of distress in credit markets despite COVID-19 and the back-up in government bond yields over the past few weeks. For example, the U.S. 10-year yield has risen from a low of 50bps to 94bps.
Are we reaching peak tech? In terms of their reach into our everyday lives, we very much doubt it. But it may be that we are reaching a peak in the earnings growth of the very largest companies as a function of their size. On the one hand organic growth becomes more and more difficult (and we’d expect some takeover attempts between the FAANG peer group over the next twelve months); on the other hand, governments are making more serious attempt to rein them back. Witness the Chinese pulling the float of Ant, and the EU anti-trust investigations into Google.
We also note that market leadership generally rarely lasts more than ten or fifteen years, perhaps because of some of the self-limiting arguments above. So we suspect that after at least ten years the era of Growth stock outperformance is approaching its limit. We cannot predict the timing of the catalyst for change, but we are happy to make a prediction what it will be: – a rise in inflation expectations.
There’s another article to be written on this subject, but our hypothesis is that inflation pressures are starting to shift from the monetary inflation which has been rife over the last twenty years towards cost inflation. Once again, there are straws in the wind, but little evidence in the headline numbers quite yet. We will be writing in more detail on this in our annual end of year review of inflation, now in its ninth year.
So, is there a case for buying Value today? I was on a recent panel at #LGPS live where for different reasons the panellists all thought so. My argument was based on the fact that value stocks tend to pay income, whereas growth stocks don’t. Even if it takes five years for the turn to come, investors are being paid well to wait.
Please contact us if you’re interested in learning more about these subjects or what Linchpin does.