Value stocks are popular

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BUSINESS CLASS. After years of lagging, the value management style was able to hold its own. This is why.

For ten years, the growth-oriented approach has borne fruit. As of March 31, 2022, the iShares S&P500 Growth Index posted an average annual return of +16.8%, compared to +11.9% for the iShares S&P500 Value Index. Over the past five years, this gap has been even wider, with an average annual return of +19.9% ​​for the growth index, compared to +11.1% for the value index.

Yet growth stocks have recently delivered less scintillating returns. Is the interest rate hike there for anything? Many analysts think so. Since the price of a security in the stock market reflects the future profits of the company, these cash flows must therefore be discounted at a higher interest rate, causing the value of these companies to fall today. Rising interest rates can undermine the earnings potential of these stocks.

In addition, the US MSCI Growth Index’s expected P/E ratio is currently 27.6 and was at its peak around 34-35 (interview given on April 20). “With the rise in interest rates, we see a compression of this multiple. It could still deflate knowing that the median will be around 22 in five years,” said Hugo Ste-Marie, director of portfolio strategy and quantitative analysis at Scotiabank World Markets.

A value investor looks for companies that have underperformed and whose share price is trading below intrinsic value. “We hope that the discount will decrease and that the title will be rated upwards again in the future,” said Hugo Ste-Marie. By intrinsic value, we mean the value of a company’s tangible assets (factory, inventory) and that of its intangible assets (patents, trademarks, expertise). An equity security can have both a high intrinsic value and good growth potential. “Current securities or value sectors may also change category over time,” said Scotiabank’s strategist. Think of the bursting of the internet bubble at the turn of the millennium. In the wake of the stock market crash, many of these technology companies became value stocks.

How do you determine if a stock has devalued enough to warrant investor attention? The managers each have their own analysis grid and different ratios are looked at. The most common is the share price/book value. This is the one researchers use to determine whether a premium is attached to securities (see box). Basically, you want to find companies that are cheap and have a low price-to-earnings and price-to-book ratio relative to the industry or market.

One might also look at the dividend yield, the price-to-earnings ratio based on estimates for the next 12 months and the Shiller ratio using net earnings per share adjusted for the consumer price index over a 10-year period. This last piece of data helps determine whether a company is overvalued or undervalued by comparing its current price to an inflation-adjusted history. “We will then classify the securities according to each of these factors and list the top 30 in Canada or the top 50 in the United States of securities that we could favor,” specifies Hugo Ste-Marie.

The energy sector stands out at the top of the list. Think of oil and gas companies, energy and utilities and pipelines. Then there is the natural resources sector, which is made up of manufacturing and mining industries that focus on commodities such as metals, minerals and chemicals. Financial services stocks also stand out with higher value scores.

Beware of the one-size-fits-all approach

Those who only have growth stocks have been biting their fingers for a few months now. Is it time to completely abandon this style to bet on devalued securities? “Not necessarily. Our portfolio is all about calibration. We want to be well diversified,” recalls Hugo Ste-Marie. We could take the economic context into account. “By holding a portfolio of only value stocks, we need to understand that we can have a return below the market,” warns Raymond Kerzérho, research director at PWL Capital.

“Growth is part of a company’s value. You don’t necessarily want to buy a devalued company. Instead, we look for quality titles at a reasonable price with profitable business models, competitive advantages or high barriers to entry,” said Philippe Le Blanc, Chief Investment Officer at COTE 100.

Today, the value stocks that stand out are often in the energy and consumer staples sectors. “Even if economic activity were to slow down, demand in these sectors should remain robust due to the green transition,” added the Scotiabank analyst. Let us think of the batteries of electric vehicles, for which copper in particular has to be extracted. Infrastructure investments will remain significant and require different base metals. Supply is further constrained by past under-investment in the mining, oil and gas sectors. The geopolitical context linked to the war in Ukraine also contributes to the price of energy, not to mention the prices of wheat and fertilizers driving up food prices.

Selecting value stocks requires expertise and time. If you don’t want to do it yourself or want to use an active manager, you can buy exchange-traded funds that track a value stock index. In the United States, for example, we find the iShares Russell mid-cap value (IWS, US$111.23), management expense ratio (MER) of 0.23%) or the Vanguard small-cap value (VBR, US$162.92, MER 0.07%). In Canada, iShares Value tracks the performance of the Dow Jones Canada Select Value Index (XCV, $34.93, MER 0.55%). We could also account for the sectoral concentrations of the major indices by favoring the Canadian market over the US market as it is more concentrated in the energy, financial services and natural resources sectors, all of which are value themes at the moment.

Is there a premium?

Investment companies have always tried to show that certain strategies can stand out. Value-based management is no exception. We are trying to determine whether these stocks, which are considered cheap, have delivered excessive returns in the past and whether this outperformance will be maintained in the future.

“Most university studies are concluded with a premium value,” said Raymond Kerzérho, research director at PWL Capital. The latter refers to various analyzes by Fama and French on US securities. There are also excess returns in the period from 1992 to 2019, when this premium was abused. The researchers called this period a random event. Fama and French also conclude in 2017 that there is a value premium in the European markets, Japan and the Asia-Pacific region (data from 1990 to 2015).

Until last year, value stocks were cheap. “I wouldn’t be surprised if valuation ratios for value and growth stocks return to their historical normals,” notes Raymond Kerzérho. The expansion of the ratios, he said, was fueled by a general investor preference for growth stocks. Value stocks are often overlooked and viewed as riskier stocks. But the theory says we will see excessive returns over a very long period of time.

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