by Eli M. Salzmann, Portfolio Manager, and David Levine, Portfolio Manager, Neuberger Berman
There are portfolio managers working today who have never seen persistent outperformance by U.S. value stocks in their careers. Some analysts were in middle school the last time value had a good run.
That is remarkable for an investment style that had exhibited systematic outperformance for decades, according to scores of academic studies. Favoring stocks that trade at relatively low multiples of their earnings has often been held up as the essence of prudent investing.
So why has value lagged growth for over a decade? And why do we think the tide may be turning at last?
Stimulus
Two big reasons can be found in the headlines that have dominated markets, and our CIO Weekly Perspectives, over recent weeks: expectations for economic growth, and expectations for inflation and interest rates.
Since the financial crisis of 2008 – 09, global economic growth has been subdued. In that environment, investors primarily look for assets that are expected to grow their earnings faster than the prevailing rate of GDP growth. That, by definition, puts growth stocks in favor.
By contrast, in a relatively high-growth environment it is generally easier to find growing earnings and investors focus instead on how much they are paying for those earnings. That, by definition, favors value stocks.
Last week, the Organisation for Economic Co-operation and Development (OECD) updated its global growth forecasts. It now expects the economy to grow by 5.6% this year, up significantly from its December estimate of 4.2%. This is partly due to an expected rebound from the pandemic-induced recession, but there is more to it than that. The OECD raised its forecast for 2022 growth, too, from 3.7% to 4.0%.
That reflects the anticipated effect of a $30 trillion fiscal stimulus already passed globally, combined with historically accommodative monetary policy and a spike in excess savings waiting to be spent.
Rebound
Interest rates also matter in the tussle between growth and value stocks, because they help determine the discount rate used to value future earnings. The lower they go, the higher the present value of those earnings. Also, crucially, the further into the future earnings are expected to be booked, the bigger the effect of changing rates.
By definition, a growth company’s earnings will be more heavily weighted to the future than a value company’s earnings. All other things being equal, its valuation will therefore rise further and faster in an environment of declining rates. In 2007, the U.S. 10-year Treasury yield was 5%. During last year’s pandemic, it fell to less than 0.4%.
As growth and inflation expectations have risen over recent weeks, however, rates have rebounded substantially. The U.S. 10-year yield has jumped to more than 1.5%.
An environment of rising rates and steepening yield curves is a major headwind for highly interest rate-sensitive growth stocks, but much less so for value stocks. Moreover, there is one value sector, financials, whose “borrow short and lend long” business model positively benefits from these conditions.
New-Cycle Conditions
Rising growth, inflation and interest rate expectations are not the only reasons we think investors should remember the place of value investing in portfolios. After 13 years of outperformance, we also think growth stocks are relatively expensive and may dominate portfolio exposures more than many appreciate.
But we do believe these are compelling reasons why the Russell 1000 Value Index has outperformed the Russell 1000 Growth Index by almost 10 percentage points so far this year, and why we see the same pattern in the MSCI World Value and Growth Indices.
We believe these value-supporting, new-cycle conditions could persist for many quarters to come.
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