Despite its underperformance over the past decade, value investing is not broken, but neglected. This article discusses how the recent de-rating of many stocks during the pandemic has led to the neglect of value and the potential opportunities this presents.

Introduction

Over the past decade, value investing has experienced underperformance, leading many to question whether it has experienced an existential crisis. However, we believe that the widespread de-rating of many out-of-favor stocks during the pandemic does not seem justified and will be reversed in due course. In this article, we discuss the neglect of value investing and the potential opportunities this presents.

Best Returns Usually Come from Cheap, High-Quality Stocks

While paying a premium for higher quality or faster-growing companies is not unusual, the best returns over the longer term are generated by cheap and higher quality companies. However, since 2017, cheap and high-quality companies have been left behind, while expensive stocks have almost exclusively been the best performing. This has been sustained by a “fear of missing out” mentality and the disruptive nature of technological change, benefiting a handful of well-known stocks. Nonetheless, this dominance of momentum cannot be sustained indefinitely.

Can Today's 'Glamour' Stocks Justify Their Valuations?

The five largest US stocks trade at 31x 2021 earnings per share, a 70% premium to the rest of the index. Although their profitability and growth justify this premium, it remains uncertain how much of this is already discounted. The expectations built into the lofty premiums associated with today's glamour stocks are unlikely to be realized, making their continued outperformance dependent on beating current analyst expectations by a significant margin for yet another decade.

Are Cheaper Companies Structurally Impaired?

The strongest argument against the return of value is that the business models of cheaper companies are structurally impaired, justifying their deep discount. However, outside longer-term losers from the pandemic and sectors facing cyclical headwinds, we find little evidence that the earnings prospects of cheaper companies have deteriorated. We argue that the neglect of value is due to the market’s fixation on a small group of winning stocks, rather than any structural impairment in value stocks themselves.

Quality is Crucial to Successful Value Investing

We believe that better businesses (higher quality) will perform well over the long run, but it is critical to be selective and understand what we are buying within value. At present, the broad-based neglect of value means that there are many affordable opportunities across most sectors and regions. These include many traditionally defensive areas such as telecoms, health care, and some consumer staples.

Conclusion

The strongest argument for why value tends to outperform growth over the long run is that investors ultimately overpay for growth. While it has experienced underperformance in recent years, the neglect of value is due to the market’s fixation on a small group of winning stocks, rather than any structural impairment in value stocks themselves. This has led to low market breadth and a level of index concentration not observed in several decades. The neglect of value presents potential opportunities, particularly in traditionally defensive areas such as telecoms, health care, and some consumer staples.