Is the value trade here to stay?

Insights from Morgan Stanley Research

04/08/21

Value stocks are back—but for how long? As part of joining forces with Morgan Stanley, E*TRADE customers now have access to the intellectual firepower of the combined company—the Quantitative Equity Research team dug into whether the value trend has staying power.

The former wallflowers of the market—value stocks—are suddenly the belles of the ball. After more than a decade of underperformance, both the Russell 2000 Value Index and the Russell 1000 Value Index were recently beating their respective growth indexes by more than 10 percentage points this year.

Chalk it up to increased optimism that some of the hardest-hit parts of the economy are poised for recovery, along with expectations for higher inflation and rising yields, which make pricier growth stocks less appealing.

The question now is whether the value trade has staying power. A recent analysis by Morgan Stanley's Quantitative Equity Research team suggests that there's more to the story than the usual value vs growth debate—and that different factors, sectors, and securities within value may not have reached their full potential.

Here are three things investors may want to consider about value's resurgence.

1. Time to look beyond value sectors

A value stock is viewed as a “bargain” relative to company fundamentals. So, while a company’s earnings and growth prospects may be solid, the stock still trades at low price-to-book (P/B) or price-to-earnings (P/E) multiples. Investors typically look to value stocks for steady dividends or because they believe their prices will rise in the future. Growth stocks, on the other hand, seldom pay dividends, but have significant potential for price appreciation.

Investors tend to associate value with a handful of sectors, such as consumer staples, energy, financials, materials, and utilities. In the early stages, a rising tide of value can boost stock valuations across these sectors.

However, this definition of value also tends to be oversimplified. Traditional value sectors can include high-priced growth stocks, while typical growth sectors, such as information technology, can also have their share of value names. In fact, value has done well within most sectors over the past year.

2. Rising rates are key to the story

While the initial surge in value stocks was due to vaccine-related optimism that the hardest-hit parts of the economy would bounce back, rising interest rates are a significant reason the value trade may have staying power.

When interest rates are trending higher, as they have been since late last year, it can clip the wings of pricey growth stocks, whose valuations are predicated on future returns. When rates go up, it raises the bar on far-out profits needed to justify today's stock prices.

Because value names are typically mature companies with valuations based on current cash flow, rising rates don't have the same impact. At the same time, many traditional value sectors, such as financials, directly benefit from rising rates.

Morgan Stanley's US rates strategists recently raised their yield forecast further above consensus estimates and expect the 10-year Treasury to end the year at 1.7%, with a bear case of 2%, which should support further rotation towards value.

3. Value performance varies by factor

While the widely held definition of value is a stock that is underpriced relative to its fundamentals, exactly what fundamentals—or what’s called factors in the quantitative world—are most relevant isn’t set in stone. This illustrates another reason the value trade may still have legs: Different value factors tend to perform better at different stages.

Deep value factors, such as book-to-price or tangible book-to-price, usually rally first, when actual levels of rates are still low. Other value factors, such as earnings yield or free-cash-flow yield, tend to pick up later, as rates rise above trend.

Source: ClarFi, Morgan Stanley Research


Source: ClarFi, Morgan Stanley Research


Bottom line: Now that rates are close to their longer-term trend, intrepid investors may want to consider exploring undervalued stocks across a wide range of industries.

The source of this Morgan Stanley article, Is the Value Trade Here to Stay?, was originally published on March 23, 2021.
 
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