Why the value rally has legs, and three funds to take advantage

The stars seem to be aligned for value shares. Here’s why the rally looks like it has legs.

The past 18 months or so have been a good period for value stocks, more specifically, since “Pfizer Monday” (on 19 November 2020, when Pfizer (NYSE:PFE) and BioNTech (NASDAQ:BNTX) announced the successful outcome of their Covid-19 vaccine trial) triggered a shift in sentiment.

From the start of October 2020 to 31 March 2022, the MSCI World Value Index has outperformed the MSCI World Growth Index by approximately 18%. While this number in absolute terms may not get too many investors excited, it is the duration of this value recovery which is of some significance.

Prior to this, the decade marked the longest and most pronounced period of value underperformance ever. There were fleeting periods of value outperformance such as the fourth quarter of 2018 or fourth quarter of 2016, but in both instances the rally didn’t last, and growth stocks continued their march upwards, led by the US FAANGs.

Even in this 18-month period it hasn’t all gone value’s way. With global growth expectations slipping back in the third quarter of 2021, growth stocks outperformed. This led value to all but give up the outperformance it had delivered over the prior 12 months.

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Value shares are proving more resilient than growth 

However, year-to-date value stocks have been more resilient than growth stocks, as the war in Ukraine cast more doubt that inflation would be “transitory” i.e. would subside as supply-chain bottlenecks built up by the pandemic eventually dissipated. The war and subsequent sanctions imposed on Russia have exacerbated inflation by impacting the energy markets, while Ukraine and Russia are also the leading exporters of grain and wheat, and higher prices are being felt in this area as well.

Why has this been better for value? Well, there are many investment-related factors, but arguably the most prominent is the vulnerability of growth stock valuations to market interest rate rises – a concept we’ve addressed in a previous article.

Perhaps a more pertinent question on investor’s lips is will it continue?

As already mentioned, the current duration of value's outperformance of growth is already the longest since the end of the financial crisis, which is encouraging, but perhaps more so is that on practically any metric value stocks are still trading on extremely low valuations relative to growth stocks. This indicates that there may be still room for value’s current run to go.

Furthermore, the last time the valuation spread between value and growth stocks was as wide was during the tech bubble of the late 1990s, which was then followed by the strongest value cycle on record (from March 2000 to December 2006). Compelling valuations aside, the economic recovery potential and inflationary environment are both factors that should continue to bode better for value.

The historical numbers support this, with US value stocks outperforming the US market following the last 14 recessions and outperforming over almost all inflationary periods since 1940.

Three of our favourite value funds

UK: Jupiter UK Special Situations

The cheapest developed region, with investor sentiment turning sour following the 2016 Brexit referendum and the bottoming out of commodities, which impacted some of large UK companies involved in mining and oil and gas companies in the UK index. There has also been a notion that the UK market is comprised of old economy companies that offer little by way of innovative growth.

Japan: Man GLG Japan CoreAlpha

Like the UK, foreign investor sentiment towards Japan has been flighty. Part of the reason is due to its skew towards old-economy stocks and away from the sectors that have thrived during the last few years, such as technology. Like the UK, this has given Japanese equities a value tilt.

US: Dodge & Cox Worldwide US Stock

Although, understandably, the US is not front and centre of investors mind when they think of value investing there are several sectors still considered cheap relative to their history. Given the size of the US market and its importance in any investor portfolios, an allocation to value stocks is prudent diversification.

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What the trio have in common

All three funds share a common overweight to the financial sector, which is the largest component of many value indices. The fortunes of the sector are very much correlated on both the level and direction of interest rates as they benefit from net interest margin expansions during periods of steepening yield curves. Higher interest rates may also boost the returns of their short-term investments.

From a process perspective, the funds do differ as you would expect, as does the type of qualities they look for in a company. However, a common thread is their investing philosophies, which should hold true for all good value investors, and includes a contrarian mindset, and being disciplined and patient.

We should conclude by saying that we are not going all-in on the continued outperformance of value, but for investors, we do advocate a more blended approach to one's investments as we look ahead, particularly given the under-representation of value across many portfolios.

Andrew Jayne is a senior analyst at Morningstar Investment Management.