Playing offense and defense with value stocks

It's a widely held view these days that stocks are richly valued and that the odds of a market correction are rising. In some cases, elevated P/E ratios may lend support to these observations. Our view is that investment opportunities with compelling valuations can be found across sectors and that a value-oriented investment strategy can provide an important buffer against the inevitable market correction.    

Contrary to popular sentiment, we find that there's much to like in the cheaper, or deeper value, segments of the market. To illustrate this point, we divided the large-cap universe into quintiles based on price-to-normal earnings and assembled their key fundamental statistics, then compared the cheapest companies with companies in the fourth—and not even the most expensive—quintile. While companies in the fourth quintile are almost three times as expensive as the cheapest companies in terms of their price-to-book values, their fundamentals, as measured by trailing 10-year return on equity and revenue growth, are essentially the same.

With some investigation, in other words, we were able to identify high-quality opportunities among large-cap U.S. stocks that are trading at discounts to the broader market. Near-term controversy leads to the valuation discount, but our research is focused on identifying those opportunities with attractive long-term prospects.    

In today’s bull market, investors have bid up a select group of stocks in the technology sector that are also some of the market’s largest components. In many respects, these technology-focused names define the new paradigm of future economic strength, across pervasive forms of consumer technology, social media, and e-commerce platforms that are playing ever more important roles in consumers’ lives. However, we can't help but turn to history to ask whether buying what everyone already owns has appeared to be a good strategy. We found that owning the largest stocks, which, not coincidentally, tend to be some of the most richly valued stocks, generally hasn't been a winning strategy for longer-term investors.    

Steering clear of the most crowded trades may be worth considering. Focusing instead on value stocks, which tend to harbor investment controversies that often push prices down, can lead to more attractive opportunities to long-term investors, provided they're well researched and understood.    

Our internal models suggest that value stocks offer double-digit return opportunities fairly consistently, even during periods of elevated valuations in the broad market. To test this proposition, we examined the forward five-year performance of value stocks from the beginning of market corrections; since 1960, there have been 13 such periods.    

On average, value stocks returned 10.8% annualized over five years from those market peaks, significantly outpacing the broader market. As our table shows, value tends to struggle in the wake of financial crises. However, even following the market peaks in 2007 and 2010/2011, value stocks returned 4.2% annualized, on average, over the ensuing five years. In virtually every other type of correction, including the overvaluation-driven correction in 1987, value stocks have shown unmistakable resilience.

This analysis gives us reason to believe that the odds are on the investor's side for value’s ability to generate attractive returns going forward. While no one can reliably predict the timing of either market correction or recovery, we do know that it's easy to miss meaningful upside by avoiding value stocks because of fears of a possible market correction.