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Value shares in 2021 – time to shine?

We look at the history of value investing and share our outlook for value shares in 2021.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Around 30 years ago, two famous economists published a paper showing American stocks trading on low valuations often did better than stocks trading on high valuations. The same result has been found in studies looking at other countries.

This has been called the “value factor”.

The graph shows how value stocks have performed better than growth stocks from 1975 to 2007 (just before the financial crisis). Growth stocks caught up briefly during the dotcom bubble in the late 1990s, but value quickly pulled away again in the early 2000s.

Value vs Growth in US Stocks 1975 - 2007

Source: Refinitiv Datastream, S&P 500 Value and Growth indices, 31/12/2020. Past performance is not a guide to the future.

Value isn’t in vogue

However, value has been outpaced by growth since the financial crisis in 2008, especially in the last few years.

Value vs Growth in US Stocks 2009 - 2020

Source: Refinitiv Datastream, S&P 500 Value and Growth indices, 31/12/2020. Past performance is not a guide to the future

It’s been a difficult time to be a value investor recently. Fast growing, highly-valued tech stocks have soared, meaning value investors have largely been left behind.

Why did value ever outperform growth?

There are two main theories about why value stocks performed better than growth stocks in the past, and why they might do so again.

The first being share prices are often cheaper because they carry more risk. Given the choice between two investments with equal expected profits, most investors will naturally choose the least risky investment. This means riskier investments must offer the potential for higher returns, or investors wouldn’t buy them.

This “risk based” theory says value investors were buying riskier companies, and that’s why they got higher returns.

The second theory is behavioural. This theory suggests some companies and sectors get hyped up by investors which drives their share prices higher. Other companies then become deeply unfashionable, and their shares can be picked up by value investors for cheap.

We saw this during the dotcom bubble. Exciting, but often unprofitable, tech stocks soared to high valuations while traditional companies got left behind. The bubble eventually burst and value investors enjoyed another period of strong returns.

So why has value underperformed in the last decade?

Times have changed

During the dotcom bubble lots of highly-valued tech stocks weren’t making money, but that’s not the case today. Some well-known companies are loss making, but on the whole, the American tech giants are making money hand over fist.

You could argue the internet has changed the game and old industrial companies just aren’t bargains anymore. Their lower valuations might be fully justified.

Better investors

Detailed financial data has become more easily available in the last few decades and investors might‘ve got better at valuing companies. More accurate valuations should mean there are fewer undervalued and overvalued stocks – taking away the value investor’s edge.

Lower interest rates

Interest rates often affect share prices.

If interest rates are high, investors can buy government bonds and collect an attractive rate of return at relatively low risk. If interest rates are low, government bonds will return less. Investors will then look to the stock market for a better rate of return which pushes share prices higher.

Over the past few decades interest rates have fallen to record lows, driving the price of shares up as they’ve become more popular with investors.

Yield on UK Benchmark 10 Year Government Bond

Scroll across to see the full chart.

Source: Refinitiv Datastream, 02/01/21. Past performance is not a guide to the future.

Young, fast-growing companies often don’t pay dividends to begin with, but aim to pay out large dividends in the future. This means their valuations will be more sensitive to falling interest rates as investors won’t be missing out on much while they wait.

Falling interest rates could be one of the main reasons for value’s underperformance. The gap between value and growth has widened more recently. We think this is because investors expect low interest rates to stick around for the long haul.

Value spreads

You might expect value to perform better when the difference between highly valued and lowly valued shares is large. There’s good evidence to support this idea, although remember that market timing is a lot harder to get right in practice than in theory.

We’ve plotted the average PE Ratio for the most expensive shares over the average PE ratio for the least expensive in the FTSE 100.

PE Spread

Source: Refinitiv Datastream, HL, 02/01/2021. Past performance is not a guide to the future.

The gap is widening again, which fits with value’s recent underperformance.

No pain no gain?

Cliff Asness, the founder of quant fund AQR, which uses systematic value strategies said this in a recent message to investors.

“the most common question I get (and these often come from fellow believers) is, “how the heck can I stick with these strategies?””

Clearly, it’s very hard to stick with your investment strategy when it’s not going well. However, if it was easy everyone would do it and the approach would stop working. This might well be true of value investing.

So where is value heading?

In the long run we think value will turn around.

Although it’s impossible to say for sure, we think falling interest rates explain a lot for value’s recent underperformance. This might mean we’ll have to wait for rates to settle before value begins to recover ground on growth.

But we might be wrong.

Importantly, market timing is hard to get right, and value isn’t destined to recover just because it’s underperformed recently.

That’s why it’s essential for investors to be diversified, that way you avoid putting all your eggs in one basket. So, while we think it’s important investors keep at least a toe in the value camp, that doesn’t mean anyone should be abandoning growth either.

Find out more about diversification

This article isn't personal advice. If you're not sure if an investment is right for you make sure you ask for advice.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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