After value stocks underperformed in the second quarter, some investors wonder whether the value recovery has run its course. We don’t think so, as three big trends that fostered a historic run-up in growth stock multiples over several years have only just begun to unwind.
Equity style returns have been volatile in 2021. During the second quarter, the MSCI World Value Index advanced by 4.6% in local currency terms, lagging the MSCI World Growth’s 10.7%. But value stocks posted strong returns over the first six months of 2021, gaining 15.8% and outperforming growth.
Short-term style swings have hardly dented the huge discount of value stocks. By the end of June, value stocks traded at a 52% discount to growth stocks, remaining near the record 53% that prevailed at the end of 2020. Much of that discount was driven by multiple expansion of growth stocks in recent years, which accounted for 82% of the performance differential to value since 2015, as we explained in a previous blog.
That valuation gap was created by three long-term trends: (1) the fall in interest rates, (2) an increase in the premium paid for revenue growth and (3) a divergence in risk premiums amid weak economic growth, the pandemic-induced recession and a more uncertain future.
Interest Rates and the Value–Growth Gap
Interest rates are always an important influence on stock performance, but even more so today. Major central banks have pledged throughout the COVID-19 crisis to keep rates at historically low levels for an extended period, and falling interest rates disproportionately benefit growth stocks.
Low rates flatter growth because a stock’s value is determined by the present value of its future cash flows. Since cash flows of growth companies are typically generated much further in the future than those of value companies, a decline in the discount rate used to calculate the present value disproportionately benefits growth stocks. In the illustrative Display below, two stocks generate identical cumulative cash flows over a 25-year period. But because the timing of when these cash flows are generated differs, a decline from 5% to 2% in the discount rate applied to these cash flows would fuel a 62% increase in the fair value of a growth stock, but only a 43% rise for the value stock.
Investors Are Overpaying for Revenue Growth
Beyond the effects of interest rates, the macroeconomic environment has influenced equity investors in many ways. For example, in a world of low and uncertain growth, investors have prized revenue growth.
Over the last 10 years, global growth companies—as expected—posted stronger earnings growth than did value counterparts. Almost all the earnings growth came from increased revenues. And investors have rewarded growth companies, even though their earnings growth has been more volatile than that of value companies.
In a world of scarce growth, it’s easy to understand why investors prize tangible revenues. However, the question is whether that revenue gap really justifies the 82% difference in multiple expansion between value and growth stocks since 2015.
Risk Premiums Diverge Amid Extreme Uncertainty
The fundamentals of value stocks have actually been relatively resilient. Why, then, were investors so pessimistic? During 2020 in particular, we think the extremely uncertain outlook for the economy and perceived disruption in certain industries played a big role in pumping up the perception of value stocks as being overly risky. Meanwhile, many growth stocks were viewed as quite safe and insulated from the economic environment.
Value stocks are indeed generally more sensitive to the macroeconomic cycle. However, we’re taken aback by the extent to which the discount rate used for value stocks versus growth stocks has been recently disconnected from historical norms.
Our analysis shows that the perceived risk of value stocks, relative to growth stocks, jumped as the pandemic spread throughout 2020 (Display). The red dots represent the excess risk premium that investors have assigned to value stocks versus growth stocks amid different economic growth expectations. The teal dots represent monthly observations between 2013 and February 2020, when the risk premium that investors demanded for value stocks was clustered closely to the regression line, peaking at just over 3%.
In 2020, this tight relationship was torn apart by economic uncertainty. With the pandemic raging, expected economic growth collapsed. As this happened, the risk premium that investors demanded for value stocks relative to growth stocks jumped to between 4% and 5%—well beyond the typical range since 2013. Surprisingly, value’s excess risk premium remained at these historically elevated levels, even as expected nominal growth recovered to 6% by the beginning of 2021, leaving value priced at a record discount to growth.
This phenomenon can be explained partly by the continuation of historically low interest rates. But we believe that the extraordinary risk premiums reflect the impact of extraordinary uncertainty and, with it, an unusually wide range of expected outcomes for economies and companies. As a result, stock multiples became disconnected from any semblance of historical norms.
In the recent six-month value rally through April, we received a glimpse of what could happen when these three trends begin to unwind. Signs of confidence in the economic recovery, a further reassessment of revenue growth and another move up in interest rates should continue to unleash more pent-up return potential in value stocks that we believe is long overdue.
- Avi Lavi
- Chief Investment Officer—Global and International Value Equities; Portfolio Manager—Global Research Insights