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Value – disrupted but not destroyed

Heather McPherson, Portfolio Manager,
T. Rowe Price US Large‑Cap Value Equity Strategy

Following another year in which US growth stocks have extended their unusual cycle of outperformance over US value stocks in terms of both duration and magnitude, investors may be wondering if something has radically changed.

Historically, over long periods of time, value stocks have outperformed growth stocks by a substantial margin. However, that has not been the case for more than 13 years as of December 2019, the longest period of growth dominance on record.

After such cycles of extreme underperformance, there usually has been a sharp and sudden reversion to outperformance by value. But now, with technological change and disruption having driven growth stock performance for so long – forces showing few signs of abating – does that mean the historical cycle of mean reversion is dead or dampened?

Value changed, not destroyed

While the tech disruption has driven many growth stocks higher,
it has generally collapsed the profit margins of many value stocks, made them very cheap, and posed heightened existential risks for some. That means that investors shouldn’t just wade into value stocks and buy companies based on their potential for mean reversion alone, McPherson says.

“You have to be even more thoughtful about value stock investing than in the past,” she says. “Eventually the growth‐value performance cycle will turn, but you have to really do the necessary research to understand the fundamentals of value stocks and their competitive threats.”

While disruption has made value investing much more difficult, McPherson says, the classic value investing model has not fundamentally changed.

Sudden reversals of fortune

Given growth stocks’ extended period of outperformance, it may be tempting to consider aggressive moves into and out of growth and value. However, this can be a costly strategy as changes in style leadership and relative performance can happen very quickly. As shown in the chart below, being just one month late in the reversal from growth to value cycles in the last 10 transitions, dating back to 1929, could have cost investors an average of 13% missed outperformance, and being a quarter late could have cost an average of 28%.

Finally, growth’s strong outperformance has left value negatively correlated with other assets that investors tend to hold, so rather than a ‘one or the other approach’, adding some value exposure to a portfolio can provide diversification benefits. It is also important to diversify within value sectors. Just as there has been a growth‐value cycle, there are also cycles in which value stocks with certain metrics (EBITDA or earnings before interest, tax, depreciation, and amortization; price‐earnings; enterprise value‐to‐sales; etc.) have led the way. This kind of diverse approach to value investing creates the potential to deliver less volatility, and potentially smoother excess returns over time.

What we're watching next

“We are watching to see whether interest rates will turn higher”, says McPherson. She says this “could have a pretty dramatic impact on value versus growth,” because disruptive companies might have less access to capital to fuel their ongoing growth. Also, the business models of financial stocks, which are often value stocks, would likely be better support by higher rates. Finally, higher rates might be tied to higher inflation, which could boost other value sectors like commodities and materials.

“A lot would depend on why debt is getting more expensive
– whether it is the normalization of rates or a credit problem, which could be tricky for value,” she adds. “We’ve had 10 years of expansion with subdued inflation. If reflation takes hold, we would expect value to pick up.”

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The following risks are materially relevant to the strategy highlighted in this material. Transactions in securities of foreign currencies may be subject to fluctuations of exchange rates which may affect the value of an investment. The value approach carries the risk that the market will not recognize a security’s true worth for a long time, or that a security judged to be undervalued may actually be appropriately priced.

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