Value Stocks - At The Cusp Of Re-Rating

|
Includes: DIA, IWM, QQQ, SPY
by: Ati Ranjan

Summary

In December 2015, the US Federal Reserve began a process to normalize interest rates through an increase in federal fund rates, the first increase since 2006.

This reversal in interest rates will compel portfolio managers — who follow traditional growth and value investing approaches for stock selection - to revisit their strategies.

While value investing has been under-performing since the 2008 financial crisis, growth investing has been elevated on the shoulders of excess liquidity and low interest rates.

Although valuations for both growth and value companies are susceptible to fluctuating Fed rates, in a rising interest rate regime, growth companies witness a greater contraction in valuation multiples.

I have co-written this article with Hitesh Jain, Senior Manager, Investment Research & Analytics, Aranca

Click to enlarge

Value Investing, a Bottom-up Approach

In December 2015, the US Federal Reserve decided to normalize interest rates with an increase in the federal funds rate for the first time since 2006. This reversal in interest rates is compelling investment managers to revisit their strategies. Traditionally, portfolio managers follow the growth and value investing approaches for stock selection. Under growth investing, a portfolio manager selects stocks with high bottom-line growth, return on equity (ROE) and profit margin and low dividend yield. Given their potential to generate high profit and cash, such businesses are typically sectoral bellwethers. On the other hand, value investing focuses on companies that operate on a robust business model, but record a reasonable stock valuation due to various factors. Although valuation multiples such as PE, EV/EBITDA and P/BV are generally lower for value businesses, these offer high dividend yield. That said, one must follow a bottom-up approach while investing in value stocks. The focus should be on selecting individual stocks and not the sector, which may face headwinds due to macroeconomic factors.

Key financial numbers (average) for MSCI World Growth and Value indices (2004-15)

Bloomberg

Click to enlarge

Value investing underperforming since 2008 financial crisis

Since the financial crisis in 2008, central banks in developed nations have adopted loose monetary policies. This has resulted in a decline in the bond yield from sovereign nations. The low yield environment has encouraged portfolio managers to add risky assets with high growth potential to their portfolio, thereby increasing the valuation multiple of growth assets. Currently, the MSCI World Growth Index is trading at the highest PE multiple of 24.3x in a decade vis-à-vis the average of 19.8x from 2005-15. Meanwhile, the MSCI World Value Index is trading at a PE multiple of 16.5x vis-à-vis the average of 15.6x over the last 10 years (2005-15).

Interestingly, in 2008, both indices formed a trough when the interest rate cycle started trending downwards. During this year, all markets witnessed earnings contraction due to the global financial crisis. Consequently, the valuation multiple for the Growth and Value indices peaked in 2009. After 2009 (when the interest rate dipped to the lowest level), the valuation gap between the MSCI World Growth and Value indices reached the highest level of 9.20x during mid-2015. Although the valuation gap corrected eventually, it remains way above the 10-year average of 4.27x. The MSCI World Growth Index has been outperforming the MSCI World Value Index since the financial crisis in 2008. The MSCI World Value Index's underperformance continued in 2015 with the widening of the valuation gap.

TTM PE multiple of MSCI Growth and Value indices

Bloomberg

Click to enlarge

Value investing outperforms growth amid historical Fed rate hikes

Since 1985, the relationship between growth and value investing has been consistent throughout the interest rate cycle. Value tends to outperform during periods of rising interest rates, while growth tends to outshine when loose monetary policies are adopted. All other factors being constant, declining interest rates benefit growth assets more than value assets. Central banks generally adopt a loose monetary policy to spur economic growth and counter low inflation. During this period, growth is unmanageable; hence, the performance and valuation of growth stocks exceed those of value stocks. The loose monetary policies adopted by developed nations in the aftermath of the 2008 financial crisis have boosted the global equity market. Value investing usually outperforms when the monetary policy is tightened, as witnessed after the recession in 1990 and during the dotcom bubble. Value investing outperformed growth by 18.5% during 1992-94 and by 50.8% during 2000-06; this is precisely when the monetary policy in the US was tightened.

Fed fund rate vs. difference in annual % return between MSCI World Growth and Value indices

Bloomberg

Click to enlarge

Under growth investing, a greater proportion of the value of a firm lies in the future. When interest rates rise, the discount rate at which free cash flows are discounted increases, leading to a decline in the value of the firm. In other words, lower discount rates increase a firm's value. On the other hand, under value investing, a firm is in a more mature stage of its lifecycle. Thus, the impact of changes in the discount rate on its free cash flows is lower.

During 2007-15, the MSCI World Value Index marked its longest period of underperformance vis-à-vis the MSCI World Growth Index; however, this is expected to change in the near future. Between 2004 and 2006, the US Federal Reserve raised interest rates 17 times to slow the overheated economy and curb the escalating inflation levels. Despite the rate hikes, equities continued their strong performance. However, there was wide disparity in the performance of growth and value investing. In fact, although the valuation multiple contracted, value investing outperformed growth investing during this period.

The chart below highlights the MSCI World Value Index's outperformance over the MSCI World Growth Index during 2003-06.

Fed fund rate, YoY % change in MSCI World Growth and Value indices

Bloomberg

Click to enlarge

Valuation multiples of growth companies more susceptible to changes in monetary policy

Valuation multiples expand or contract in tandem with changes in the Fed's interest rates. We have demonstrated this relationship using a simple derivative of the justified PE multiple. The company's justified PE multiple is calculated using the (ROE-G)/(ROE*(K-G)) formula, wherein ROE is the return on equity, K is the cost of equity and G is the sustainable growth rate.

Financials such as ROE and the long-term growth rate are determined from the MSCI World Growth and Value indices. ROE is the average from 2004 to 2015 and the long-term growth rate is the CAGR from 2004 to 2015. While calculating the justified PE multiple, we have used the same cost of equity.

Based on our calculation, the growth company has a justified PE multiple of 24.0x, while the value company's corresponding multiple is 12.8x. The primary factor for the difference between the justified PE multiples is the higher ROE and long-term sustainable growth rate.

Sensitivity of justified PE multiple of MSCI World Growth and Value indices to interest rate

Aranca Calculations

Click to enlarge

As seen in the chart, the growth company's PE is more sensitive to an increase in the interest rate compared with the value company. The valuations of both companies decline; however, the valuation of the growth company decreases by a higher percentage point compared with the value company.

Value investing may turn around in 2016

The US Federal Reserve's 25bps hike in the interest rate in December 2015 is just the beginning of a series of increases expected in 2016. Economists argue that the Fed could raise the interest rate by as much as 100bps during the course of the year, supported by lower unemployment rate, a marginal increase in wages, and a rise in inflation. However, recent turmoil in the Chinese stock market may delay these rate hikes. Despite the risks, we are likely to witness an increase in interest rates in 2016. This would act as a catalyst for re-rating value stocks and drive their outperformance over the next few years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.