Value investing is due for a high return

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FT editor Roula Khalaf selects her favorite stories in this weekly newsletter.

The writer is the founder and president of Research Affiliates

Value investing is deeply unpopular in an AI-fueled era of the “Magnificent Seven” tech stocks, which continue to dominate the US stock market despite recent price declines.

Globally, investing by focusing on identifying undervalued stocks rather than seeking out fast-growing companies has soared from its relative outperformance peak in early 2007 to its peak in the summer of 2020, with subsequent returns from bottom at the end of 2021 and again some. weeks ago.

In a recent interview, CNBC anchor Steve Sedgwick told me, “At the end of his career, Muhammed Ali rested on the ropes, taking punches, letting his opponent wear himself down, a tactic called ‘rope-a-dope.’ As a lifelong value investor, you have to feel like you’re playing a tightrope against a growth market dominated by growth.” I loved the analogy! Although he (and I) may have felt punch drunk, Muhammed Ali came back, time and time again, to score a knockout.

Why bother with value? Unless we truly believe that value companies will never come back, they deserve a decent allocation in our portfolios. There are four reasons why value can make an amazing comeback in the coming years. First of all, they are cheap. If we compare the ratio of stock price to book value of the cheapest 30 percent of stocks in the world stock market to the most expensive 30 percent, the value is normally about a quarter – 25 percent – as expensive as the growth .

In 2005 to 2007, value was expensive by historical standards, with this relative valuation level hovering near 40%. By the summer of 2020, however, value stocks were left for dead, as cheap relative to growth stocks as they were at the height of the dotcom bubble. They are now one-eighth (12%) more expensive than growth stocks. In fact, the market says that the Magnificent Seven and the most expensive stocks will eventually grow eight times over the boring stocks.

Second, not all of value’s prolonged underperformance was due to trending underlying fundamentals such as earnings growth. A portfolio of value companies was doing well, with such factors rising roughly pari passu with the growth stock portfolio. Shockingly, if the 2005-2007 relative price-to-card ratio had been maintained, the value would have exceeded the increase over the entire period of 2007!

Third, value reliably beats growth during periods of rising inflation. Most investors would agree that while inflation could return to central bankers’ 2% targets, there is far more upside risk than downside. Inflation is more likely to average 3 or 4 percent in the coming years than 0 to 1 percent. This asymmetric risk supports a trend toward value. Why? Because higher inflation means higher interest rates. If long-term growth is discounted at a higher discount rate, it is less valuable. Also, higher inflation means higher volatility in the economy, markets and political arena. In a riskier world, investors want a margin of safety.

Fourth, growth reliably beats value in the late stages of a bull market—not so much in a bear market or the early stages of a renewed trend. If we are visited by the proverbial magnus ursus (or big bear), growth investors should beware!

How should we best take value exposure? One way we at Research Affiliates have long advocated is to select and weight stocks in a portfolio not by their market capitalization, but by the fundamental economic footprint of the companies’ business—as measured by benchmarks such as sales, book value, cash flow and dividends. By doing so, the portfolio matches the look and composition of the macro economy, not the stock market.

We introduced the fundamental index concept in 2005 to do this. The approach underweights growth stocks relative to market cap benchmarks and increases that of value stocks. As such, early critics suggested that this was just a way to repackage value investing. However, the underlying index has consistently outperformed conventional value indices, with the FTSE-RAFI All-World outperforming the FTSE All-World Value Index in 15 of the last 17 years.

When should investors step up our value allocations? My simplistic answer would be, why not now, especially if they are already heavily involved in growth stocks? A more reasoned answer would be to average in a more balanced mix of growth and value, or even take a value tilt, for all the reasons above. Ask yourself if you expect to hear an alarm bell when the bull market rally ends. If not, there is no reason why the portfolio adjustment process should wait.