Growth stocks have significantly outperformed value stocks over the past year, with a return of 30.5% versus 14.7%. And growth still beats value over 10 years, according to Morningstar indices.
Morningstar analyst Kevin McDevitt spoke to two top US value managers, David Green at Hotchkis & Wiley and Charles Pohl from Dodge & Cox, who believe that rising interest rates may finally reverse that dynamic.
Kevin McDevitt: You’ve both written about a potential recovery of value stocks. What is the likely catalyst?
Charles Pohl: The most likely one is continued strong economic growth and, along with that, rising interest rates. Historically, we’ve observed a strong relationship between interest rates and the performance of value stocks versus growth stocks, and we’ve certainly seen that in the recent period.
So, why do we believe there are return opportunities in value stocks? We have endured extremely low interest rates for the last decade, and the value/growth disparity is related to interest rates for two reasons.
If you look at the industry differences between the value and growth indices, the value indices have most of the financials, and financials themselves are very interest-rate sensitive. For the banks, they’ve been hurt by near-zero interest rates, and their earnings will be helped by higher rates.
Energy is also an overweight area in the value indices, and the price of oil and energy stocks in general are very sensitive to economic growth. Stronger economic growth around the world is going to drive rates higher, but it will also drive the price of oil higher and the earnings of these stocks higher.
David Green: If you look at history, the best performing group when interest rates go down is large-cap growth. The best-performing group when interest rates go up is small- cap value.
Over long periods of time, value has outperformed its growth counterpart historically. The last 10 years have been anomalous. The valuation spreads are quite significant now. We can have periods where we get disconnected from that, but those periods ultimately reverse.
McDevitt: Charles, looking at the challenges value stocks have had more broadly, people have speculated about the role of technological disruption. We’ve seen the Amazon (AMZN) effect on retailers, for example. How much has technological disruption caused you to rethink business models?
Pohl: We’ve spent a lot of time researching these issues. We’re also investors in some of the disruptors, such as Google (GOOGL) and Tencent (00700).
It’s no great revelation that a lot of retail spending is migrating online. This has caused at times, certainly at the end of 2017, some of the retailers to trade at big discounted valuations. That can create opportunities. The important thing to do is to stay on top of the changes.
Some of these traditional retailers come with a lot of advantages in the online world, too. They can combine the advantages of their distribution network and their physical store presences in interesting ways with the online business model, to deliver the product more quickly to customers, to maintain a greater inventory that’s closer to the customer, to allow for in-store pickup. The creative ones are adapting.
Why Have US Stocks Outperformed?
McDevitt: Are investors not willing to show patience these days?
Pohl: Low turnover creates a lot of opportunities for a long-term investor. In recent decades you’ve seen the rise of investors who are focused on very short-term events, particularly hedge funds with a clientele that’s demanding results every quarter. A lot of hedge funds are event-driven, trying to second-guess what the quarter’s earnings are likely to be.
This creates opportunities for people who are instead focused on long-term shareholder value. When we’re talking to management teams, we’re much more interested in where they want to take the business. What are their long-term goals in terms of trying to gain market share?
McDevitt: Charles, we’ve talked about the gap between value and growth. Another persistent gap has been between foreign stocks and US stocks. Do you see that valuation gap narrowing over time?
Pohl: There is a significant gap on the surface between the foreign indices and the US. We’ve asked ourselves, is it just that foreign stocks are cheap, or is there something else going on?
There are some valuation differentials, but you’ve got to be very careful. For example, the Japanese market looks quite inexpensive, and it is relative to history. But if you take a look at Japan – and this is also true for Europe – over decades, these companies have persistently earned a lower level of return on equity and lower level of return on capital relative to comparable US companies.
In Europe, economic growth has been quite weak for some time and continues to be much weaker than in the United States. That has probably created a lower valuation for some of the companies in Europe in comparison to their US counterparts – a differential that you can’t explain away with these other factors. So there are some opportunities there, and we’re trying to take advantage of those.
McDevitt: David, you run a US-based fund, but you sometimes invest opportunistically overseas. What’s your take?
Green: One of the areas that is starting to look interesting is European banks. They may be at the stage that US banks were just before we entered a rate-rising cycle here. We expect interest rates to rise in Europe, so we think that that’s an interesting area. They’re also trading at very low multiples.
