Resurgence of Value: Top Half of the First Inning?

Less than three months ago – in this December 30^th post – we presented the following chart to highlight the historic disconnect between value stocks and growth stocks.

The underlying point then, which still holds today, was that growth stocks – familiar names with exciting narratives such as Tesla, Amazon, Facebook, Snapchat, and Apple – were dramatically more expensive than their value stock brethren. In fairness, growth stocks deserve richer valuations because they represent companies with exciting prospects and attractive growth opportunities. Keep in mind, however, that growth stocks being dramatically more expensive than value stocks refers to the current relationship relative to the normal relationship. In this context, growth stocks are roughly 5.5 standard deviations more expensive to value stocks than the long-term average (using price/book as the measurement of value). In a normally distributed sample of monthly data, a relationship this extreme should occur about once every 2.2 million years.

We have all learned from experience that extreme events in finance occur more frequently than would be expected in a normally distributed sample. Yet this does not change the fact that calling growth stocks “dramatically more expensive than value stocks” – even if not a once every 2.2 million year phenomenon – probably falls on the side of understatement.

A hypothesis used to explain this unique relationship stems from the environment of historically low interest rates. The theory is that growth stocks are akin to long-term bonds with an underlying value that depends largely on future cash flows many years in the future (think of an unprofitable company like Uber where the stock’s value depends entirely on expected profitability at some point in the future). Declining interest rates make these future profits more valuable because of the reduced opportunity cost of investment alternatives (reduced discount rate). Growth stocks – because they tend to be companies relying on an expectation of high future profits – are then the beneficiaries of low or falling interest rates (just like long-term bonds). Conversely, value stocks are hypothesized to behave more like short-term bonds since they are often mature companies with current profitability where the stock price is not as dependent on large profits many years from now. Keeping with the hypothesis, growth stocks have been the overwhelming beneficiaries of historically low interest rates over the past several years. The other side of this is that rising interest rates – if and when – should favor value stocks relative to growth stocks.

In fairness, academics and practitioners debate about this interest rate hypothesis and the robustness of the relationship between interest rates and the relative performance of value and growth. Debates aside, here is what we can say with clarity right now:

• Interest rates have a clear relationship with stock prices (not value or growth stock prices…value and growth prices). All else equal, higher interest rates mean that future profits are less valuable (higher discount rate).
• Value stocks tend to be less dependent on future profits than growth stocks. All else equal, that makes growth stocks more negatively impacted by higher interest rates. Interest rates may not be the dominant factor impacting this value/growth relationship, but they are a factor.
• Interest rates have sharply increased since the start of the year as evidenced below.

• Value stocks have significantly outpaced growth stocks since the start of the year, largely in tandem with the rise in interest rates.

• Traditional value sectors such as energy and financials have been the best performing sectors in 2021 after suffering the worst performance in 2020.
• The technology sector – dominated by growth stocks – has been the worst performing sector in 2021 after posting the highest gains in 2021.

The recent rally in value stocks is a welcome result for evidence-based investors who tilt toward value stocks because of the robust historical support for a value premium. Whether this recent value resurgence is the start of a multi-year trend or not will be eventually be determined by history but the conditions are in place for it to be a multi-year trend, regardless of what happens with interest rates. It may just be that the abrupt northbound move of interest rates this year was the catalyst needed to spark a long-awaited reversal for value stocks.