In recent years, value stocks have underperformed the broader equity market. This included value-focused portfolios such as Warren Buffett’s Berkshire Hathaway, which lost 12% last year. But long-short, value-oriented hedge funds managed by gurus such as Bill Ackman (Pershing Square) and David Einhorn (Greenlight Capital) also suffered. Both funds fell by more than 20% in 2015, while the broad US S&P 500 equity index rose by a modest 1.3% on the year. So are traditional value strategies dead or is it a good time to start buying value stocks ahead of a bounce?
A seven-year lag: more to come?
The relationship between the performance of traditional value companies and that of growth companies has been skewed towards the growth side since 2008. Over the period between the last US monetary policy rate cut (on 16 December 2008) and the end of 2015, US growth stocks outperformed the wider market by 28.41%, while value stocks underperformed by 27.65%. Prima facia, that made sense as economies recovered from the Great Financial Crisis and market hopes centred on recessions ending and growth picking up.
Exhibit 1: US growth stocks have outperformed value stocks and the wider market
Source: Bloomberg, through December 2015
First, before we look ahead, a brief excursion into the world of value investing, an approach developed by Benjamin Graham in the 1930s. He stated that the investment value and average market price of common stocks tend to “increase irregularly, but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings.” According to this school of thought, irrational and excessive price fluctuations create opportunities for value investors.
Proponents of value investing also maintain that a cold, hard look at the numbers is a sound basis for stock selection. This approach has inspired successful investors including Warren Buffett, who in turn have a substantial following.
So, as we leave the crisis behind, one asks whether the heyday of growth stocks is about to end. To assess that, one could look at the characteristics of growth versus value stocks using the traditional discounted cash flow (DCF) analysis. This involves compounding a company’s estimated future cash flows and discounting these with forward interest rates to arrive at a target price for the stock.
Discounting the end of loose monetary policies
One parameter in that analysis could change in the foreseeable future – the discount factor. This in turn might create a picture that is quite different from last year’s which showed a sizeable outperformance by growth stocks and a poor performance by value stocks. If US bond yields (as a proxy for market interest rates) bottom out and the US Federal Reserve continues to work towards a normalisation of monetary conditions, the effect of the discount factor on future cash flow estimates is likely to increase. This may carry implications for companies that have different cash flow characteristics.
Value companies tend to have large near-term cash flows, whereas analysts will generally estimate growth companies only to have large cash flows in the longer term. Changing the discount factor will alter the judgement as to whether to hold value or growth stocks. Near-term, gains in the discount factor do not significantly affect the DCF analysis, but for growth stocks, it is a different story. The value of EUR 100 in estimated cash flow in 10 years’ time with a discount factor of 5.00% is EUR 61. If the discount rate changes by 1.00%, the discounted value changes by EUR 6 or about 10%.
Exhibit 2: As long-term bond yields fell, growth-oriented strategies benefited
Source: Bloomberg through December 2015
Offering value again
As global long-term bond yields fell in recent years, growth-oriented strategies benefited and value investors such as Buffett and Co. suffered. Market expectations of yields levelling out or even changing direction could set up value stocks for outperformance as their attractiveness improves with falling valuations. Indeed, the DCF valuation for all companies would by implication fall as the discount factor increases. Taking into account all factor characteristics, companies with large near-term cash flows – value stocks – would be the least affected.
This effect should make the choice between value and growth stocks the product of more of a macroeconomic and duration analysis for a larger portfolio as it becomes more of a fixed-income like duration play. So if you are undecided between investing in growth stocks or in the shares of Berkshire Hathaway and similar value-oriented portfolios, do not underestimate the value of a consultation with your fixed-income analyst about duration.
 Pershing Square -20.5% http://uk.businessinsider.com/chart-shows-pershing-square-performance-2016-1?r=US&IR=T; Greenlight Capital -20.2% http://uk.businessinsider.com/three-stocks-that-hurt-greenlight-capital-2016-1?r=US&IR=T
 16/12/2008 – 31/12/2015, comparing the S&P 500, S&P 500 Value and S&P 500 Growth indices; source: Bloomberg