Asset classes and investment strategies, much like celebrities and dieting fads, can go in and out of fashion.
Within my area of expertise, international value equities have clearly been out of fashion; as a group, value stocks have been closely associated with cyclical industries such as materials, industrials, and financials. These stocks have tended to perform well when economic fundamentals are improving. In light of the events that have unfolded in the last decade, it has been unsurprising that value stocks have fallen behind their growth peers. Value stocks' earnings dropped by 23% during that span,1 and much of the decline was attributed to falling earnings for commodities producers as prices of oil and many other commodities dropped. The financials sector also weighed on value stocks' earnings, as banks and insurance companies faced headwinds from low interest rates.
Within international equities, value posted an average annualized return, net of dividends, of 1.90% from January 1, 2006, through September 30, 2016, compared with 3.99% for growth.2 While value enjoyed a stretch of outperformance versus growth in 2013–2014, its last period of sustained leadership ended in 2005, prior to the global financial crisis.2
A change in leadership could be here
However, international value stocks could be poised to come back, as the price premium that investors have been paying for international growth equities has grown in recent years to levels that we believe may be unsustainable. The average P/E ratio multiple for growth equities rose from about 13 in July 2012 to 20 as of May 31, 2016; the multiple for value rose much more slowly from about 10 to 12.2 The increase in valuation for growth stocks was not driven by a corresponding rise in earnings, as earnings of companies in the MSCI World ex-USA Growth Index remained flat during the period.1
Where to find value
Overpaying for growth rarely ends well. From our perspective, owning staples and healthcare stocks at 27 times earnings or higher, for below average earnings growth cannot be sustainable.So where can one expect earnings growth over the next three to five years, one might ask? Interestingly, we believe it is exactly where value resides today: European financials and global industrials. We believe that investors have also been too quick to dismiss the potential for quick earnings turnarounds in these two segments of the market, and a reassessment is due. The vicious cycle of falling commodity prices and interest rates should abate as global economic growth stabilizes. Investors may be responding to some of these trends already, as value outperformed growth during the third quarter of 2016.
A comeback doesn't require a perfect environment
While it is difficult to tell at this point whether this recent performance shift is a sign of things to come, we believe that there is potential for meaningful outperformance. International value stocks have historically recorded a period of strong recovery following a period of pronounced underperformance relative to its growth partners. Traditionally, the period of outperformance would be accompanied by improvements in the macro environment, which is absent today. However, we would argue that in light of the magnitude of the underperformance in the past decade, a“perfect” environment may not be a necessary condition for international value stocks to stage a meaningful comeback. Instead, we believe the combination of stabilizing oil prices, a shift toward fiscal policy, and a stable China could be enough to trigger a recovery.
1 Bloomberg, 2016.
2 Bloomberg, the MSCI EAFE Value Index versus the MSCI EAFE Growth Index, 2016.
Price to earnings (P/E) is a valuation measure comparing the ratio of a stock's price to its earnings per share. The MSCI EAFE Value Index tracks the performance of large- and mid-cap securities exhibiting overall value style characteristics across developed markets countries around the world, excluding the United States and Canada. The MSCI EAFE Growth Index tracks the performance of large- and mid-cap securities exhibiting overall growth style characteristics across developed markets countries around the world, excluding the United States and Canada. The MSCI ACWI ex-U.S. Growth Index tracks the performance of large- and mid-cap securities exhibiting overall growth style characteristics across 22 developed market countries and 23 emerging market countries.
All investments involve risk, including the possible loss of principal. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. Value stocks may decline in price. Hedging and other strategic transactions may increase volatility and result in losses if not successful. The stock prices of midsize companies can change more frequently and dramatically than those of large companies.