Research Affiliates: Outstanding opportunity in value stocks

Research Affiliates: Outstanding opportunity in value stocks

Vitali Kalesnik (Photo Archive Research Affiliates).jpg

By Vitali Kalesnik, Director of Research for Europe at Research Affiliates Global Advisors

Value stocks are the only liquid asset class likely to generate a 5–10% real return over the next decade. Your window to buy historically cheap value stocks may close soon. Act now!

In May and June 2021, the value rebound that started in September 2020 gave back over half its gains as the third COVID-19 wave swept the globe. The Delta variant’s emergence precipitated fears of more lockdowns and reinvigorated tech stocks that were very well positioned to benefit in the COVID-19 world.

Today, value remains remarkably cheap, with valuation discounts relative to growth stocks at near-historical highs. Value was only ever cheaper relative to growth in the summer of 2020—not even during the height of the tech bubble. But as increasing percentages of the population become vaccinated and the prospects for a return to normalcy improve, the window for adding cheap value stocks to your portfolio will narrow. Time is of the essence.

So, how cheap is value?

Looking at the current valuations of value stocks versus growth stocks, we see that in most markets the discounts are not only in the cheapest decile in history, they are in the bottom half of the cheapest decile! In Did I Miss the Value Turn? we measure the value–growth discount using both the price-to-book value ratio (P/B) and a composite measure of four ratios: P/B, price to five-year average sales, price to five-year average cash flow, and price to five-year average dividends.

Both measures show that, as of June 20th 2021, all regions we analysed—with the sole exception of Australia—are in the cheapest relative valuation decile in their respective histories. Using the composite measure, their relative valuations are 95% in the US, 99% in the EU, 97% in the UK, 95% in the developed markets, 99% in the emerging markets, 96% in Japan, and 51% in Australia.

What are the implications for asset allocation?

Our long-term forecasts for the major liquid asset classes, as of the end of June 2021, showed that value stocks in the EU, the UK, Japan, and emerging markets are poised to earn the highest real return of the asset classes and value strategies we analysed. With bonds around the world priced at extremely low and even negative yields to maturity, presaging negative or near-zero annualized returns over the next 10 years, value stocks stand out as a tremendous opportunity for investors today.

Denominated in USD, EM value is projected to generate the highest real return, nearly 10% a year, over the next 10 years. Of course, investing in this sector of the market brings with it the highest levels of risk. Alternatively, we expect UK, EU, and Japanese value stocks to earn a real return of 6% to 8% a year over the same time period, likely with lower volatility than EM value stocks.

The bottom line is that even after value’s recent partial rebound, the strategy in most regional markets is still priced at very attractive valuations. In the US and developed markets, value discounts have only been this cheap or cheaper at the very height of the tech bubble and during the summer of 2020.

With most other liquid asset classes priced to produce negative or near-zero real returns in the next decade, equity value strategies are the outliers, priced to generate long-term real returns higher than 5%. These extreme valuations of value strategies, driven by the uncertainty and fear of continued pandemic-related setbacks, may prove to be short lived. A well-diversified portfolio positioned for the highest possible long-term real returns should today anchor on value stocks around the globe.

You can still catch the value turn!

The demonstrated effectiveness of vaccines, particularly in reducing the risks of hospitalization and mortality, should continue to boost the major global economies. Worldwide economic strength should accelerate as the emerging markets and other regions that were slow to vaccinate their populations make significant progress on that front. The cyclical sectors of the economy, and consequently value investors, should benefit. When peak fear rules investors’ mood, as is currently the case for value strategies, it’s time to buy, not sell.

Disclaimer: Please refer to our disclosures