Why the market is ‘not stupid’ for underestimating value stocks

Research Affiliates Founder & Chairman Rob Arnott joins Yahoo Finance to discuss why he believes value stocks will provide a 5-10% return, the effects of COVID in the market, and the expected growth of stocks in the coming quarters.

Video Transcript

BRIAN SOZZI: First, we have a treat for all you longer term investors out there that love value stocks. Here with us now is investing pioneer Rob Arnott, the founder and chairman of Research Affiliates. Rob, I know you're very busy traveling around. Thanks for taking some time to come on with us this morning. Really enjoyed your latest piece of research. I encourage everybody to check it out on your site. I sent it to a lot of my friends here. You are calling-- you say that value stocks could return 5% to 10% over the next decade. Make the case.

ROB ARNOTT: Well, that would be 5% or more over the market, not just 5% or 10%. The market is very fully priced. Value stocks are not. We're in one of the only businesses in the global macro economy where people hate a bargain. Imagine if Tiffany's put out a banner sign saying post-COVID sale, everything marked up 20%, and people were bashing down the door, trying to get in. Well, that's the way it is with stocks around the world.

One thing people forget is that just like a stock can go up and down relative to its fundamentals, a strategy can, too. And so value stocks were priced back in 2007 about 1/4 as expensive as growth stocks, a 4 to 1 ratio. They tumbled by August of 2020. They'd fallen to 1/13 the price of growth stocks, cheapening by 70% relative to growth but underperforming by 58%, only 58%. So a huge shortfall, but it's smaller than the amount by which they got cheaper. If they rebound back to a 4 to 1 ratio, you would see value outperform growth by upwards of 200%.

So that's what we're looking at in terms of the magnitude of the route for value investing and the magnitude of the opportunity for those willing to buy in today.

JULIE HYMAN: So Rob, I guess--

BRIAN SOZZI: Rob, how do you--

JULIE HYMAN: Oh, sorry, go ahead, Sozz.

BRIAN SOZZI: I'm just saying-- yeah, real quick, Julie-- Rob, how do you define a value stock?

ROB ARNOTT: There's a lot of ways to define them. The classic academic approach is to use price to book value. Now, that's very flawed in today's economy because so much of what we sell is services. And intellectual property and brand, R&D, all represent assets of a company. And they don't reflect in a book value.

So one of the things that we've done is to look at price to book value adjusted for intangibles. It works about twice as well as classic price to book. Price to sales ratios, price to earnings ratios, price to dividends plus buybacks-- these are all good measures of whether a stock is cheap or expensive.

Now, expensive stocks are better stocks. The companies are better. The market's not stupid. It pays a premium for companies that are better that have a good outlook, have good management, have good product. Value stocks are out of favor for a reason. They are out of favor because their products are out of step or their management is kind of dumb. And what's interesting is all of that's known. It's in the price.

So a growth stock is only going to help you if it does even better than lofty expectations. A value stock will hurt you only if it does even worse than bleak outlook. And so the opportunity is top up the value, trim the growth, take those wonderful profits from growth having performed so spectacularly, and top up the really cheap out of favor stocks. Some of them are going to disappoint, but a lot of them will turn out to have been true bargains.

JULIE HYMAN: Rob, this only works if people actually step in and buy these value stocks, right? I mean, you can--

ROB ARNOTT: Absolutely.

JULIE HYMAN: --scream from the heavens all you like about them being bargains. If people don't buy them, it doesn't do much good. People are starting to buy them, right? We are starting to see-- I mean, we've seen some sort of back and forth switching between growth and value over the past year, value starting to regain a little bit of ground here. Financials, for example, the best performers for this quarter. How sustained do you think that is going to be? We've seen investors be pretty fickle here.

ROB ARNOTT: They sure are. They're changing their minds a lot. So from last September until mid-May, Russell value beat Russell growth by about 20 percentage points. That's a huge margin. But in the prior eight months, value had underperformed growth by 40 percentage points, which is the biggest margin in such a sport short span in the history of the US stock market. Value went ferociously out of favor because the COVID lockdowns led everyone to believe that there were going to be sweeping bankruptcies, and they would affect the companies with thin profit margins, sluggish growth, the value stocks.

And lo and behold, the sweeping bankruptcies didn't happen. Yes, there were bankruptcies, but not a lot of them-- not that much more than in a normal year. And so, they started to come back. With the delta variant making its way across the globe, we saw that surge in value retrench and retrace from mid-May until mid-September, with value underperforming growth by over 10%, giving back half of the gains and then some.

And what we found is that they're now regaining their footing. People are beginning to realize that while they're no longer 1/13 as expensive as growth, they're still 1/11 as expensive as growth. That is cheap. And the growth stocks, meanwhile, are expensive. There was a wit in the 2000 bubble who described the tech bubble stocks as discounting not only the future, but the hereafter. I think that's what we're seeing for a lot of the tech stocks-- valuations measured not in price to earnings, not in price to dividends, but in price to sales.

And when you get to 10 or 20 times the sales of a company, the growth has to be stupendous for investors to get their money back. And many of these companies will produce wonderful growth. Cisco is a great example. In the year 2000, it was the most valuable company in the world for all of about three or four weeks. It has since then-- for 21 years, it's grown its sales at 12% a year, its profits at 13% a year. And yet, the share price is not anywhere near where it was in the year 2000. So with wonderful growth for 21 years, the stock is still down. Isn't that interesting?

BRIAN SOZZI: Rob, you do-- and that's what I wanted to ask you about. You know, you do write in this latest piece that tech stocks are priced to generate negative real returns. You know, how much of an influence are higher interest rates in that call?

ROB ARNOTT: Higher interest rates are more of a popular narrative than a driver of growth versus value. If you go back historically and look at different markets around the world, you find that the growth value cycle isn't that much affected by interest rates. But a narrative can create a self-fulfilling prophecy. The markets are driven by narratives on a short-term basis by narratives far more than long-term relevant facts.

And the narrative is that very low interest rates allow stocks to be more expensive, sustainably more expensive for a long period of time, and that growth stocks, because they're discounting a much longer future. A lower discount rate makes them worth more relative to value.

Well, that's only true in the context where interest rates can be low because the real rate is low because people don't require a high yield to be willing to own bonds. Or it can be because growth expectations are diminished. If it's growth expectations diminished, watch out. That would not be good for the growth stocks. But when we look around the world, we find the link between interest rates and the growth value cycle to be startlingly weak, much weaker than most people would realize.

BRIAN SOZZI: Always learn something talking to you. Rob Arnott, the founder and chairman of Research Affiliates, have a great rest of the week.