It’s been another somewhat frustrating year for US value investors as cheaper, out-of-favour but fundamentally sound companies have been left behind by the runaway train of technology growth stocks.
The dominance of growth over value has been such that the Russell 3000 Growth index has risen 25 per cent year-to-date whilst the Russell 3000 Value index has limped along with a meagre 8 per cent return. Indeed, through June, growth has been thumping value by the most since 2000.
However, there’s good reason to believe a reversal may come for US value in 2018 on the back of continued strong economic growth and rising interest rates. This potential shift in market leadership may see the information technology stocks that have charged ahead give up some ground to higher quality dividend payers and start to play towards the strengths of price-conscious value investors.
Value stocks tend to outperform growth stocks when interest rates are rising – a path that looks all but inevitable for the US. With the Federal Open Market Committee set to hike rates in December, and possibly three or four times next year, the direction for short-term interest rates is assuredly (if incrementally) up.
While rising rates will eventually become a headwind for all equities, we are likely quite a ways from that juncture, as low and rising rates signal healthy economic growth and a modest pickup in inflation. If rates inch up because the economy is healing to the extent that it no longer needs extraordinary monetary support, that’s a positive for stocks.
In recent months we’ve seen a welcome but unusual synchronisation of strong global economic momentum, a trend which may in time reduce the premium investors are often willing to pay for growth in more lacklustre periods. Indeed, in terms of the breadth of global growth, the first half of 2017 was the best start to a year since 2011. A surge in economic momentum in Europe and Japan, solid corporate earnings globally and continued steady performance by the US have helped equities continue to power upwards.
With this above trend economic growth, combined with higher rates of inflation on the back of further tightening in the US labour market, it seems reasonable to expect that the gap between value and growth may finally begin to close. Amongst the sectors that we would expect to come back into favour are financials, particularly banks, which should be beneficiaries of higher net interest margins as rates grind upwards.
We have actually been building out our financial services exposure since after the financial crisis, when many companies were priced as if they were going out of business. Of course that valuation disparity has narrowed, but financials are still priced today at about a 20 per cent discount to the market. As a result we have found a lot of companies in the space which meet our investment criteria of high quality, attractive valuation and a 2 per cent yield or more. It surprises many people that there are names in this sector that have paid a dividend consistently for over a hundred years. However, looking forward, we think the financial sector has significant potential to raise dividends as well as.
The key to having exposure across financials is remaining well diversified at the sector level to balance risks. For example, I own six regional US banks – not because I can’t make up my mind about which companies I like best, but because factors such as what happens to a general region or the yield curve or the regulatory landscape could impact each company very differently.
The bottom line is that good companies that are attractively valued and pay a dividend will outperform over time – period. Different investment styles may cycle periodically in and out of fashion, but long-term investors in US equities who focus on quality first, who know that the price you pay is critical and ultimately focus on the names that can deliver a consistent income stream over time will be well placed to ride through the cycles.
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