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Seth Klarman Calls for a Comeback From Value Stocks

Value investing is undoubtedly one of the most famous strategies, and many legendary investors, including Warren Buffett (Trades, Portfolio), have continued to highlight the importance of adopting this strategy for many decades.


However, the performance of value stocks trailed behind that of growth stocks for the best part of the last decade and especially the last year, raising questions regarding the success of this technique.

Source: CNBC/Factset

Billionaire hedge fund manager Seth Klarman (Trades, Portfolio), who runs Baupost Group, does not agree with the critics. In a letter to investors dated Jan. 23, 2020, he defended sticking by value investing even though the performance of the fund lagged behind that of the S&P 500 Index in 2019:


"To be sure, today's trend-following environment has left Baupost looking flat-footed, as some of the publicly-traded bargains we identify and accumulate drift relentlessly lower - even as we believe they demonstrate their underlying value in several ways."



Commenting further, Klarman noted that monetary and fiscal policy easing have played a major role in this outperformance of growth investing strategies but concluded the letter by confirming his view that undervalued companies will deliver the best returns in the long term:


"Fortunately for Baupost, investing is not a sprint but a marathon. Over the long-run, major share mispricing will be corrected as short-term illusions are pierced and enduring characteristics become more apparent and shine through the noise."



Before reaching any investment conclusion, however, it's important to assess whether or not value investing can break the trend and deliver alpha returns in the next few years. To do this, a fundamental understanding of when these strategies typically provide attractive returns is essential.

The big picture

As illustrated above, growth outperformed value in the last decade. However, ten years is not a long period when it comes to investing. Therefore, to gain a more robust view of the performance of these two techniques, let us extend the time period to 20 years. This should provide some reasons for value investors to have confidence.

Index

Total NAV returns (past 20 years)

iShares Russell 1000 Growth ETF (IWF)

185.2%

iShares Russell 1000 Value ETF (IWD)

274.9%



Source: Reuters

The big picture is supportive of value investing, and a research report prepared by Dimensional Investing concludes that based on empirical evidence, value investing will stage a comeback at some point:


"On March 31, 2000, growth stocks had outperformed value stocks in the U.S. over the prior year, prior five years, prior 10 years, and prior 15 years. As of March 31, 2001 - one year and one market swing later - value stocks had regained the advantage over every one of those periods."



Historical returns and performance indicators, however, can only go so far in demystifying what the future holds. Therefore, a good starting point is to identify the reasons behind growth's outperformance in the last decade and determine whether those fundamentals are finally changing.

Investing in growth stocks was a no-brainer in 2009

The financial crisis was not forgiving, especially for companies that were trading at very high valuation multiples based on expected earnings growth. The drastic drop in stock prices eventually led to both value and growth stocks trading at approximately similar price-earnings ratios. This is something that had never happened previously, as it doesn't make sense for both types of companies to trade at similar multiples.

Source: CFA Institute blog

As expected, the multiple expanded sharply following the fallout of the crisis and led to a significant outperformance of growth stocks, which, in all fairness, should have been expected by value investors back in 2009.

A comeback might be around the corner

The global macroeconomic environment has a lot to do with which strategy will come out on top in a certain time period. Over the last decade, favorable monetary policy decisions, tax cuts and continued economic growth helped one strategy stand out from the other. However, as the business cycle develops, value might once again be the winner. Historical evidence points out that growth outperforms when the economy recovers from a recession and until it reaches maturity.

Source: Franklin Templeton

On Jan. 20, the International Monetary Fund released its growth projections for the U.S. economy, and as many suspected, growth is projected to slow down considerably through 2021. This is typically a sign that an economy is entering a mature phase until reaching a peak before reporting negative numbers. When this happens, consumer spending will decrease and companies will no longer be in a position to report stellar revenue and earnings growth, which could prompt investors to flight the same way they have done in previous recessionary environments. Value stocks have consistently provided better returns under such circumstances.

Source: Franklin Templeton

The Federal Open Market Committee (FOMC) confirmed in December that a rate cut is not on the cards for 2020, which is another reason to believe that a monetary policy boost will not be available for markets in the year ahead. The macroeconomic environment points to slow and steady growth of the economy, which is an ideal backdrop for value stocks to gain traction.

The valuation gap

Gautam Dhingra, Ph.D., CFA, who serves as the CEO of High Pointe Capital Management, developed a dividend discount model in 2018 to determine the fair price-earnings ratio for both growth and value indexes. Below are the results of his model.

Source: CFA Institute blog

According to data from BlackRock, growth stocks are currently trading at a price-earnings ratio of 31 in comparison to a multiple of 17.7 for value stocks. While the entire market seems overvalued based on this analysis, value stocks are considerably cheaper on a comparative basis. On the other hand, these numbers represent the Russell 1000 indexes and there could be several companies that are trading well below the fair value as recommended by Dhingra.

Investors can use popular stock screeners, including the All-in-One Screener available at GuruFocus (a Premium feature), to find companies that are trading at attractive valuation multiples. It's important to conduct thorough due diligence once a stock has been identified before reaching any conclusion as some companies deserve to trade at depressed levels due to a lack of growth opportunities, poor financial health or both.

Analysts are now turning bullish on value

After a decade-long silence, many renowned analysts have recommended betting on bargain stocks in the last few months. Two of the most noteworthy comments can be found below.

Research Affiliates analyst Rob Arnott wrote:


"We've seen more and more people give up on the idea of value investing, which we think is a little strange because we're in the only major industry in the global macroeconomy where people hate bargains. Value has been battered down now for 12 years, most particularly from 2015 to 2019, so the last five years have been daunting. Value is cheap."



Gotham Funds co-chief investment officer Joel Greenblatt (Trades, Portfolio) wrote:


"Value has been significantly challenged. I believe that is unlikely to continue. Just as 1999 was followed by three of the best years of all time for value, we believe that we are setting up for a great opportunity for value now."



Growth stocks might still have some legs

It may not be wise to give up on the idea of growth investing just yet. Some companies that fall into this category, including Apple Inc. (NASDAQ:AAPL) and Facebook, Inc. (NASDAQ:FB), have healthy balance sheets with minimal debt and are continuing to improve their revenue on a consistent basis. A few earnings beats are on the cards in the next couple of years, which might push shares of these companies to new highs. Even when it comes to growth investing, investors can still find bargains, which would delay the resurgence of value stocks for a bit longer.

Takeaway: A blended strategy might be the most effective

The outperformance of growth might be coming to an end, but it's impossible to project when value will start delivering alpha returns to investors. High-quality companies like Amazon that have grown exponentially over the last decade could continue to keep their momentum intact due to competitive advantages over peers. Therefore, turning a blind eye to these companies could prove to be a mistake, and as an investor, striking a balance between the two strategies might be the best way forward in the next five years. From 1978 through 2018, a combination of growth and value delivered very attractive returns.

Source: Franklin Templeton

An investor focused on benefiting from the revival of bargain stocks can consider the below exchange-traded funds (ETFs).

  • Invesco Small-cap 600 Pure Value (RZV)
  • Invesco Russell 2000 Pure Value (NYSE:PXSV)
  • ProShares Russell 2000 Dividend Growers (SMDV)
  • SPDR 600 Small-cap Value (SLYV)



When selecting one of these ETFs to invest in, it's important to consider the overall risk profile, since the beta figures listed by fund houses on their websites do not consider the correlation with existing constituents of a portfolio.

Disclosure: I do not own any stocks mentioned in this article.

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This article first appeared on GuruFocus.