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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is founder and chairman of Research Affiliates
Value investing is wildly unpopular in an AI-fuelled era of the “Magnificent Seven” technology stocks that still dominate the US stock market despite recent price falls.
Globally, investing with a focus on identifying undervalued stocks rather than looking for fast-growing companies floundered from its relative-performance peak in early 2007 until its nadir in the summer of 2020, with subsequent bounces from the bottom in late 2021 and again a few weeks ago.
In a recent interview, CNBC anchor Steve Sedgwick said to me: “Late in his career, Muhammed Ali rested on the ropes, taking punches, letting his opponent wear himself out, a tactic called ‘rope-a-dope’. As a life-long value investor, you must feel like you’re playing rope-a-dope against a growth-dominated bull market.” I loved the analogy! Though he (and I) may have felt punch-drunk, Muhammed Ali came back, again and again, to score a knockout.
Why bother with value? Unless we truly believe that value companies will never come back, they deserve a decent allocation in our portfolios. There are four reasons that value may well stage a stupendous comeback in the years ahead. Firstly, they’re cheap. If we compare the ratio of the stock price to the book value of the cheapest 30 per cent stocks of the world stock market with the most expensive 30 per cent, value is normally about one-fourth — 25 per cent — as expensive as growth.
In 2005 to 2007, value was expensive by historical standards, with that relative valuation level hovering near 40 per cent. By the summer of 2020, though, value stocks were left for dead, as cheap relative to growth stocks as they were at the peak of the dotcom bubble. They are now one-eighth (12 per cent) as expensive as growth stocks. In effect, the market is saying the Magnificent Seven and the most expensive stocks will eventually grow eightfold relative to the boring value stocks.
Secondly, the entire prolonged underperformance of value was not due to the trend in underlying fundamentals such as earnings growth. A portfolio of value companies was doing fine, with such factors growing roughly pari passu with the portfolio of growth stocks. Shockingly, if the relative price/book ratio seen in the 2005-2007 period had been maintained, value would have outperformed growth over the entire span since 2007!
Thirdly, value reliably beats growth during periods of rising inflation. Most investors would agree that, while inflation may well revert to the central bankers’ 2 per cent targets, there’s considerably more upside risk than downside. Inflation is more likely to average 3 or 4 per cent in the years ahead than 0 to 1 per cent. This asymmetric risk supports a bias towards value. Why? Because higher inflation means higher interest rates. If long-term growth is discounted at a higher discount rate, it is less valuable. Also, higher inflation means higher volatility in the economy, the markets and the political arena. In a riskier world, investors want a margin of safety.
Fourthly, growth beats value reliably in the late stages of a bull market — not so much in a bear market or the early stages of a renewed bull trend. If we are visited by the proverbial magnus ursus (or great bear), growth investors should watch out!
How should we best take on value exposure? One way we at Research Affiliates have long argued for is to select and weight stocks in a portfolio not by their market capitalisation, but by the fundamental economic footprint of the companies’ business — as measured by benchmarks like sales, book value, cash flow and dividends. In so doing, the portfolio matches the look and composition of the macroeconomy, not that of the stock market.
We introduced the fundamental index concept in 2005 to do this. The approach reduces the weighting of growth stocks compared with benchmarks based on market capitalisation, and raises that of value stocks. As such, early critics suggested that this was merely a way to repackage value investing. However, the fundamental index has relentlessly outpaced conventional value indices, with FTSE-RAFI All-World beating the FTSE All-World Value index in 15 of the past 17 years.
When should investors ramp up our allocations to value? My glib answer would be, why not now, especially if they are already heavily committed to growth stocks? A more reasoned answer would be to average into a more balanced blend of growth and value, or even take on a value tilt, for all of the above reasons. Ask yourself if you expect to hear an alarm bell signalling when the growth bull market is done. If not, there is no reason the process of portfolio adjustment should wait.