…. and the fixer-upper factor: why value isn’t broken

Andrew Dyson
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Value is poised for a major comeback that could “generate some of the best returns in a quarter century”, according to a recent research paper by US quantitative and multi-asset shop, QMA.

The study, published last month, says value stocks have been heavily beaten down over the last 18 months despite underlying fundamentals that belie the pessimism.

US value stocks, in fact, racked up returns in three months in 2019 to date that rank among the top 10 worst performances for the factor since 1996, the analysis says.

“Such extreme levels should not be alarming. Rather, we view this as the backdrop for incredible investment opportunities,” the QMA study says. “… The magnitude of both cheap stocks’ underperformance and the outperformance of expensive stocks (in particular, fundamentally weak expensive stocks) is, from our perspective, an unjustified and irrational overreaction. Historically, overreactions like this have led to massive corrections. Following the Tech Bubble and GFC, corrections were in excess of 30 per cent for value factors!”

The analysis split returns from value stocks into two components – namely “changes in the price-to-forward earnings ratio” and forecast earnings growth data – for both the Russell 1000 and 2000 indices dating back to 1996 to assess whether the investment style was “broken”.

“In a value trap environment, we would expect a greater deterioration in fundamentals,” the study says. “In the last 18 months, we have actually seen an improvement in fundamental earnings for value stocks, but a deterioration in pricing. This combination is unprecedented, and signals the opposite of a value trap environment.”

Furthermore, the QMA research found investors had bid up “expensive” stocks despite disappointing fundamental growth data.

“While risk concerns have contributed to overreaction on the downside, there also appears to be a clear dislocation on the upside among expensive stocks, as the market chases what could best be described as speculative growth,” the report says.

As well as the statistical analysis, the QMA study found “corporate insider activity” – or directors and management trading their own stock – suggests internal confidence is high among value companies.

“The relative conviction of insiders regarding cheaper stocks is higher than ever, which reinforces our conviction about the magnitude of the performance opportunity from here,” the paper says.

QMA says several factors could trigger the value reversion, including:

  • a reduction in “policy uncertainty”;
  • either a sustained increase in global growth or “a full-blown recession”; and,
  • regulations that rein-in the monopolistic behaviour of “disruptive innovators” and encourage competition.

“A rebound in value could also stem from something as simple as a single growth stock having a significant earnings miss, leading investors to reevaluate the whole space (e.g., Netflix?),” the report says. “It could also occur as investors finally acknowledge and begin to trust the earnings yield differential.”

However, the QMA study – produced by a panel of authors, including QMA chief, Andrew Dyson – warns against timing the market pivot, arguing that maintaining an “exposure to value is the best approach”.

QMA is part of the US$1.3 trillion multi-affiliate PGIM group, the asset management arm of New Jersey-headquartered insurer, Prudential Financial.

– David Chaplin, Investment News NZ

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