Value Stocks - At the Cusp of Re-rating

Published on 15 Jan, 2016

Value Stocks

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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), profit margin, and low dividend yield. On the other hand, value investing focuses on companies that operate on a robust business model but trade at a subdued valuation relative to their sound fundamentals.

Value Investing Has Been Under-performing Since the 2008 Financial Crisis

Since the financial crisis of 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 a PE multiple of 24.3x — its highest in over 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 from the last 10 years (2005-15).

By mid-2015, the valuation gap between the MSCI World Growth and Value indices reached the highest level of 9.20x (as compared to 10-yr average of 4.27x). The MSCI World Growth Index has been outperforming the MSCI World Value Index since the financial crisis in 2008.

TTM PE MSCI World Growth Indices

TTM PE MSCI World Growth Indices

Amid Fed Rate Hikes, Value Investing Outperforms Growth

Since 1985, the relationship between growth and value investing has been consistent throughout the interest rate cycle.

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.

Fund Rate vs Difference in Return%

Fund Rate vs Difference in Return%

During 2007–15, the MSCI World Value Index marked its longest period of under performance 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 an overheated economy and curb escalating inflation levels. Despite the rate hikes, equities continued their strong performance.

There was wide disparity in the performance of growth and value investing however. In fact, although the valuation multiple contracted, value investing outperformed growth investing during this period.

As evident in the following chart, the MSCI World Value Index outperformed the MSCI World Growth Index during 2003-06.

Fund Rate vs YoY%

Fund Rate vs YoY%

Valuation Multiples of Growth Companies are 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.

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.

Value Indices vs Interest Rates

Value Indices vs Interest Rates

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.

Vale 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 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 out performance over the next few years.