Market Memo: Is it value time?
It’s true the equity market generally has been kinder to growth than value stocks in this post-crisis bull market, but there are signs this is clearly changing.
Over the past year, large capitalization value stocks—so-called because they represent big companies selling at discounts to their historic price averages and their perceived intrinsic values—have outperformed large-cap growth stocks, so-called because their earnings and stock prices are viewed as being on the rise. New data from Morningstar shows this outperformance has extended to small-cap and mid-cap domestic equities this year.
We’re not surprised. According to financial advisor and Seattle investment manager Paul Merriman, history shows that over the past 82 years, value stocks have outperformed growth stocks 82% of the time in each five-year period. In 10-year periods, the outperformance rises to 89%; for 20-year periods, it’s 100%! So while the past five years have been unusual, it could be that the averages are reverting to the mean, which means it could be a very good time for long-term equity investors to consider value stocks—all the more so if what many are calling the “great rotation,’’ the movement of individual investors back into stocks and out of cash, is truly underway. ISI Group says equity fund flows are on track to reach $62 billion the first two months of 2013, the highest in nine years and a sharp reversal from the record outflows of the past five years.
M&A may add a little gas
There are other reasons to like value stocks. Our research puts the current price-earnings ratio for large-cap value stocks at about 11.8 times earnings versus a long-run average market P/E of about 14 times, indicating value stocks are trading at significant discount to the broader market. If value stocks were just to revert to the market’s historical norm, it would represent an 18% return, and that doesn’t account for potential sales and earnings growth and underlying fundamentals that could drive valuations higher if the global economy is indeed on the verge of a prolonged uptrend and if merger & acquisition activity begins to take off (as evidenced by Thursday’s $40 billion-worth of deals that were led by the $23 billion buyout of iconic food giant H.J. Heinz). According to Dealogic data cited by the Wall Street Journal, there have been $160 billion of M&A transactions so far in 2013, the fastest start to a year since 2005.
We’ve always liked value stocks because we think that, over time, they prove their value to long-term investors—and do so with less risk (their historical standard deviations are smaller than they are for their growth counterparts). Is it any coincidence that such great stock-market investors as Benjamin Graham, Warren Buffett and Peter Lynch were value investors? We think not. But if we also are on the verge of the return of the individual investor, a surge in M&A activity and a pickup in the global economy (assuming both Congress and the White House don’t undermine the private sector’s apparent momentum and the worst is behind Europe), we like value stocks even more.