Forget Growth Stocks, 2017’s All About Value

For anyone with more than a decade in the markets, the “value premium” is almost a sacred rule. The idea that stocks with lower valuation premiums would beat their more expensive “growth” peers is almost a given.

Nobel laureates Eugene Fama and Kenneth French first identified the value premium in 1992, comparing returns on high book-to-market value stocks against low book-to-market stocks. It’s one of the three factors in their asset pricing model built to explain excess returns in a portfolio.

Since the financial crisis, the outperformance of value stocks has been called into question, with growth stocks easily besting their value peers. The shift has turned the traditional investing theme on its head, and even one guru of value investing has questioned the future of cheap stocks.

But economic realities are catching up to growth investing and value stocks may be ready to retake their dominance. 

Two economic scenarios await investors over the next several years — and neither is good for growth stocks. When one of these futures begins to take shape, value names may prove to be the only path to profits.

The Death Of Value Investing Has Been Greatly Exaggerated
The value investing theme played out year after year in the past. Stocks of companies in the Russell 1000 Value Index outperformed more expensive names in the Russell 1000 growth index by a cumulative 161% over the 18 years through 2007. 

Investing in companies with cheaper valuations was the saving grace for many investors throughout the last two bear markets. Over the nine years through 2008, the value index was able to nearly break-even as growth investors saw their portfolios cut in half.  

Not only have value stocks outperformed but they’ve done it with less risk. Since 1990, the value index has posted a standard deviation of just 16.7% compared to the more volatile 21.4% annual deviation in the growth index.

The rule has broken down since the last recession though, with the growth index besting value stocks by a cumulative 85% since 2009. 

Noted value investor and co-founder of money manager GMO, Jeremy Grantham, discusses the changed dynamic in his most recent quarterly report to investors. He cedes that the surge in profitability over the last decade has shifted the premium in favor of growth stocks, with higher corporate profit growth justifying ever-higher valuations for faster-growing companies.

The biggest factor in this shift has been interest rates, kept at historic lows since 2009. While rate increases have brought the Fed Funds Rate to 0.90%, it is still just a small fraction of the 5.26% where it stood before the 2008 collapse. 

The essentially free money from the Federal Reserve and other Central Banks has meant companies could lever up their profits and use trillions in excess cash to repurchase shares to boost profits.

Getting Ahead Of The Next Era In Value Investing
Two scenarios await anyone betting on the continued dominance in growth stocks. 

#-ad_banner-#Continued economic growth in the United States and abroad may support corporate profits, but it will push interest rates higher, weighing on the mountain of debt built by companies over nearly a decade. 

Buybacks have already fallen to $115.6 billion in the third quarter of 2016, according to FactSet research, for a 28% decrease from the same quarter in 2015. Corporations will find it harder to drive higher profits in an increasing rate environment and they’ll no longer be able to artificially boost those profits with buybacks.

The other scenario is even more foreboding for growth investors. If economic growth falls, interest rates may not rise as fast, but lower corporate profits could crush stocks with the highest valuations. Value stocks outperformed growth during the worst years of the last two market crashes, by 35% in the two years through 2001 and by 3% through 2008.

Finding value stocks for the potential shift back to outperformance means looking for companies that not only have lower price-to-earnings but also those with solid balance sheets. Companies with relatively lower debt burdens have the financial flexibility to weather the storm while their over-leveraged peers crumble.

Amgen (Nasdaq: AMGN) trades for just 14.7 times trailing earnings versus an industry average of 26.3 times. That’s a 44% discount to the pharmaceuticals industry and well below the company’s average multiple of 18.6 over the last five years. 

Amgen’s debt-to-equity ratio of 1.1 is slightly above the industry average of 0.9, but the company’s next few years of debt maturities are modest and leave plenty of financial room to maneuver.

The $117 billion drug manufacturer recently energized its pipeline with cholesterol blockbuster Repatha and other potential drugs for osteoporosis and migraine treatment. In addition, its acquisition of deCODE Genetics gives it industry-leading technology to identify and validate disease targets for drug development.

Wells Fargo (NYSE: WFC) trades for a price of just 12.8 times trailing earnings versus an industry average of 15.2. That’s a 16% discount to other large banks and just above the company’s 12.1 average multiple over the last five years.

Wells Fargo is unique in its position among financials. The vast majority of its business revolves around traditional deposits and loans, making it more a peer of regional banks than of the multinational institutions that focus their business in the capital markets. However, Wells’ size advantage is undisputed against its regional deposit-gathering competitors, supporting its dominance in loan origination and servicing.

The fraudulent account scandal still hangs over shares of the $259 billion company but the bank itself is moving on to the high level of consumer trust it had before the incident. Rising interest rates should benefit Wells Fargo on the rate spread between deposits and loans, and the potential for financial deregulation could drive an earnings bonanza. 

Hanesbrands (NYSE: HBI) trades for a price of just 15 times trailing earnings versus an industry average of 21. That’s a 29% discount to the pharmaceuticals industry and well below the company’s average multiple of 22.9 over the last five years.

Brand value has helped Hanesbrands protect sales as other apparel manufacturers fight to survive in a tough brick-and-mortar retail environment. The company has seen strong online sales growth and announced a cost-saving initiative, Project Booster, this year that is expected to generate up to $300 million in incremental cash from operations and $100 million in savings through 2020.

Hanesbrands drives manufacturing efficiencies through its 52 company-owned facilities across the globe. The balanced production footprint helps it manage low-cost manufacturing with distribution, as well as control the quality of its products. It’s these size advantages, combined with the company’s brand value, that should drive the share valuation multiple back to at least the industry average.

Risks To Consider: Even if the value premium returns, some shares with low price-to-earnings ratios will underperform on company-specific factors.

Action To Take: Rebalance your portfolio back to a value theme ahead of rising rates and the potential return of value stock dominance. Diversify across value in each sector with stocks trading below industry- or sector-valuation averages.

Editor’s Note: Here’s how to protect your portfolio in Trumpnation 2017. These are our Top 10 “win-win” stocks for a chaotic 2017. No matter what Trump does (or how the markets respond) these stocks are poised to soar into double-digit gains over the next few months. Check out the list here