As we wrote in our previous blog The Great Rotation, investors have been moving away from expensive fixed income assets, such as government bonds. Instead, equities and higher carry bonds like high yield will keep on benefiting from this bullish rotation. While the investors are looking for new opportunities, also alternative asset classes such as private equity and infrastructure will continue to see positive money flows.
Currently, the greatest bubble in equity markets is the difference in valuations between (expensive) growth stocks and (cheap) value stocks. In other words, growth firms have become very expensive, especially in relative terms against value firms. This difference, also called the value premium, became stretched during the corona crisis. It was already very high before the crisis. With that in mind, this could be one of the most compelling investment opportunities in equity markets for a long time.
If bonds yields continue their rise, it will lift value themes further. The US 10-year government bond yield hit a low of 0.31% in March 2020. Since August yields have crept up and recently hit a level of around 1.5%. There is still plenty of upside risk in yields in 2021 and beyond – and this would boost rotation themes, such as value. Why?
Higher yields are bad news for growth stocks, which gain from low bond yields, since a higher proportion of their cash flows expectations are discounted from much farther out in the future. If the discount rate were to rise, it would hurt particularly these long-duration growth stocks. And, especially now since growth stocks are relatively expensive and priced for perfection.
True, US growth firms have experienced better earnings growth and been of higher quality over more than 10 years when compared to value companies. For example, growth companies have been more profitable, so there has been a good reason to pay a premium. But this fundamental excellence is not true anymore, and indeed value firms have performed fundamentally (quality measures) as well or even better than growth firms over the past year or so.
Value started to perform better than growth stocks in early November, just after the US election. This was the catalyst for the reflation theme and higher bond yields.
Focus on funds with a fundamental value strategy
We know from academic research – and from real life success of many value investors such as Warren Buffett – that value outperforms growth stocks over the very long-term. One of the reasonable explanations from academic literature explains that it is not due to the reason that growth stocks are worse companies, but because investors overpay for growth and neglect cheaper value stocks.
How to play it then? Be careful with value ETFs, since the construction of the value index may not be what the investor has in mind. Instead, funds with a fundamental value strategy could be a sensible way to go gain from the value premium, but with a lower risk of stepping into value traps – which you may counter in value ETFs. Multifactor funds also usually include value as one of many of the rewarded factors they harvest systematically to gain better long-term returns.
Peter Lindahl
