Investors who have been focused on growth and momentum stocks shouldn’t ignore the benefits of value stocks, which could soon be the ones outperforming.
Given stretched valuations, the value market offers “significant pent-up alpha,” said Conor Muldoon, fundamental portfolio manager at Causeway Capital Management LLC in Los Angeles, Calif., in a Sept. 16 interview.
Muldoon compared the current value market to that of the ’90s. “The magnitude of this period of value underperformance now matches what we saw back in the [tech] bubble,” he said.
At the bubble’s peak, growth had outperformed value for several years. In February 2000, the 10-year average annual return differential between the Russell 1000 Growth and Value indexes reached about 6.5% in favour of growth.
The tech bubble burst the next month and, in December that year, the differential was erased. Value stocks subsequently outperformed to 2007. “That was one of the best time periods to be a value investor,” Muldoon said.
Investors’ current focus on growth and momentum stocks is also concerning because those stocks are “priced for perfection,” Muldoon said. He used the IPO market as an example.
“We’ve seen lots of companies that have yet to turn any profit [and] that generate significant negative cash flow,” yet are expensively priced, he said. “To the extent that these companies disappoint, we think investors will look to exit — and that exit will happen all at once, which will lead to a significant decline in those stock prices.”
That’s when the spotlight could shine on value. “Value stocks could outperform significantly in such a scenario, given how attractively they are priced and how under-owned they are by global investors,” he said.
However, forecasting an exact turning point is “a hard call to make,” he said. “If we go back over the last four to five years, there’s actually been many false starts for the so-called value rally.”
There was no specific catalyst for the last major value cycle, which began in March 2000, he said. When tech companies disappointed, investors “headed for the exit.”
“There was no one thing that caused the turn. It was just a refocus by the investor community on fundamentals,” Muldoon said.
One potential catalyst this time could be capital allocation, which is why he focuses on bottom-up analysis at the company level. A company should be generating strong cash flow and correctly allocating it, including returning capital to investors by paying dividends and buying back shares, he said.
With share buybacks of cheaply priced value stocks, execution risk is low, he added.
Examples of such positive capital allocation are U.S. financials, including Citigroup, Bank of America and Wells Fargo. These names return “a significant amount of capital back to shareholders, and all three offer a payout yield north of 10%,” Muldoon said.
After the long stretch of growth outperformance, capital allocation is “potentially one catalyst for a change in sentiment” to value, he said.
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