Predicting when a sustained rally in value stocks may occur has proved to be a fool’s errand for the past several years, but that hasn’t stopped value managers from trying. In its latest paper on the subject, Lazard Asset Management has provided a pathway, if not a timeline.
The paper, ‘Can Investors Still Believe in the Value Premium?’ suggests that the type of divergence between growth and value seen – now for more than 10 years – is such that market participants must believe that traditional value businesses are structurally disadvantaged. In other words, this is more than just a cycle.
When people said “this time is different” in the past they have, always, been derided eventually. And painfully. In the five major rotations over the past 90 years when value has risen from the grave, it has done so very sharply.
Nevertheless, after such a long time, this time, there is little benefit in saying over and over that this can’t go on. Trusting history enough to believe that a rotation will occur at some stage, the paper, written by Jason Williams, director and portfolio manager/analyst in the Lazard ‘equity advantage’ team, maps out the likely events leading up to it. This can at least give investors a guide to how it will happen.
Williams says that there are two types of growth businesses that the market has favoured so enthusiastically, businesses with a protective ‘moat’ and those which are ‘disruptors’. Businesses with a moat typically built-up market dominance over several decades through competent management; the establishment of a recognisable, leading brand and the creation of innovative production processes. Disruptors tend to be younger, have rapid sales growth and acquire market share. They often produce little or no profits but reinvest heavily to strengthen their positions to also achieve moat status.
How growth can unravel
Few disruptors and businesses with strong moats are immune to the profound economic shock of COVID-19. Many of them have seen earnings expectations sharply downgraded even as their stock prices have recovered and valuations soared.
- Unprecedented strain on government debt and deficit dynamics triggers currency debasement. According to the Congressional Budget Office, the US budget deficit is projected to reach 16 per cent of GDP in 2020 as of mid-October. Even assuming a strong economic recovery, the deficit is forecast at 8.6 per cent of GDP in 2021, within range of the previous post-war record deficit of 9.8 per cent in 2009. In the UK, the deficit is projected to hit 15 per cent, and the government debt-to-GDP ratio is expected to soar past 100 per cent in both nations. Japan tops all other developed countries, with the debt-to-GDP ratio expected to hit 250 per cent in the coming years. Only the UK has hit these kinds of debt-to-GDP levels in the past—260 per cent during World War II. The paper says: “These trends suggest to us that we are approaching the point at which only outright currency debasement, rather than productivity enhancements and economic growth, can bring down these ratios… We believe a sustained or multi-year depreciation of the US dollar or the Japanese yen would support equities in regions that are cheap compared to the rest of the world – namely, emerging markets and Japan.”
- Inflation boosts commodity prices: During this period of extended value underperformance, commodity price inflation has been absent or even declining. In many areas, particularly oil and gas, economic growth concerns have been a headwind for a number of years while supply growth has been strong. However, commodity price inflation was evident in the aftermath of the financial crisis, when easy monetary policy weakened the US dollar. The aggressive monetary and fiscal easing in the US recently might not only support commodity prices but prompt sustained inflation as aggressive currency debasement takes place. Should that happen, extractive industries could have a dramatic turnaround. The price of precious metals such as gold has already started to rise, and that increase could feed through to more economically sensitive industrial commodities.
- Government intervention rains on the parade: Value sectors are typically well established, highly commoditised, and heavily regulated, but growth segments are constantly changing and consolidating by nature. Their relationships with the governments of countries in which they operate are not as well-formed as that of value sectors, and they can run into conflicts with sovereign states that try to ensure that they do not turn into monopolies as they gobble up market share or abuse regulatory and tax regimes. The actual changes that governments demand of these up-and-coming businesses are hugely sensitive to the degree of social and economic stress in a country and the amount of pressure from constituents to act on perceived excesses of power, special treatment, and rule- bending. While it is unpredictable, the threat of taxation, antitrust, and regulatory action on newer growth segments of the economy is real.
- We don’t know what we don’t know: Potential catalysts outlined in the paper would in most cases initially affect only a subset of value or growth stocks. However, such catalysts typically create a waterfall effect and end up boosting the performance of value assets globally, especially given how deeply entrenched the shift from value to growth assets has become at this point.
What it will look like
When a growth market has shifted to value in the past, it has often done so quite suddenly. “When we compared the rolling five-year performance of low P:B stocks and high P:B stocks in the US, outperformance of value stocks has sometimes been explosive,” Williams writes.
“We found that one of two conditions existed before the most explosive value rallies: either the overall market was trading at exceptionally low cyclically adjusted valuations, as in 1932, 1940, and 1980, or a significant polarisation had opened between growth and value stocks, as in the ‘Nifty Fifty’ period of the late 1960s or the dot-com bubble in the late 1990s.
“In each of these five instances, investors had written off value stocks as casualties either of desperately weak economies or as ‘old economy’ stocks doomed to fail in a new economic paradigm, only to see them defy expectations. Today, we have a combination of both characteristics.”
The big returns to value have tended historically to manifest in three phases: investors benefit from base effects due to the low price of a stock, profits recover and then the stock re-rates.
Index investors will be hurt most
Today’s growth concentration at the top of widely followed indices—the top 10 stocks comprise 31.8 per cent of the index in emerging markets and 18 per cent of the index in developed as of mid-October—raises the risk that investors could be disappointed with the equity risk premium they ultimately receive should the boat tip back the other way.
“Put a bit more bluntly, if the stocks that are carrying today’s market fall into a sustained slump, it could hamstring the equity risk premium for years to come,” Williams says.