Value investing is about to make a major comeback

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FT editor Roula Khalaf selects her favourite stories in this weekly newsletter.

The author is founder and chairman of Research Affiliates

Value investing is extremely unpopular in an artificial intelligence-driven era of the “Magnificent Seven” – technology stocks that still dominate the U.S. stock market despite recent price declines.

Globally, investments that focused on identifying undervalued stocks rather than finding fast-growing companies struggled from their peak in relative performance in early 2007 to their trough in the summer of 2020. They recovered from the decline from the trough in late 2021 and again a few weeks ago.

In a recent interview, CNBC host Steve Sedgwick told me, “Toward the end of his career, Muhammad Ali would rest on the ropes, take punches and let his opponent wear himself out, a tactic called ‘rope-a-dope.’ As a lifelong value investor, you must feel like you’re playing rope-a-dope against a growth-dominated bull market.” I liked the comparison! Although he (and I) may have felt drunk, Muhammad Ali always came back and scored a knockout.

Why bother with value stocks? Unless we truly believe that value companies will never get back on their feet, they deserve a fair share in our portfolios. There are four reasons why value stocks could make a huge comeback in the coming years. First, they’re cheap. If you compare the share price to book value ratio of the cheapest 30 percent of stocks in the world stock market to that of the most expensive 30 percent, value stocks are typically about a quarter — 25 percent — as expensive as growth stocks.

In 2005-2007, value stocks were expensive by historical standards, with that relative valuation level reaching nearly 40 percent. However, by the summer of 2020, value stocks were dead, as cheap relative to growth stocks as they were at the height of the dot-com bubble. Today, they are one-eighth (12 percent) as expensive as growth stocks. In fact, the market says that the “Magnificent Seven” and most expensive stocks will eventually grow eight times compared to boring value stocks.

Second, the continued underperformance of value stocks was not due to the trend in underlying fundamentals such as earnings growth. A portfolio of value companies did well, with these factors growing at roughly the same rate as the portfolio of growth stocks. Amazingly, if the relative price-to-book ratios of 2005-2007 had been maintained, value stocks would have outperformed growth stocks over the entire period since 2007!

Third, value reliably outperformed growth in times of rising inflation. Most investors would agree that while inflation could well return to central banks’ 2 percent targets, the upside risk is significantly higher than the downside risk. Inflation is more likely to average 3 or 4 percent in the coming years than 0 to 1 percent. This asymmetric risk supports a bias toward value. Why? Because higher inflation means higher interest rates. When long-term growth is discounted at a higher discount rate, it is less valuable. Also, higher inflation means greater volatility in the economy, markets and politics. In a riskier world, investors want a margin of safety.

Fourth, in the late stages of a bull market, growth reliably beats value – not so much in a bear market or in the early stages of a renewed bull trend. If we speak of the proverbial Magnus Ursus (or big bear), growth investors beware!

How should we best take value exposures? One method we have long advocated at Research Affiliates is to select and weight stocks in a portfolio not by their market capitalization, but by the fundamental economic footprint of the companies’ business – measured by benchmarks such as revenue, book value, cash flow and dividends. This way, the portfolio reflects the look and composition of the macroeconomy, not the stock market.

To this end, we introduced the Fundamental Index concept in 2005. This approach reduces the weighting of growth stocks relative to market capitalization-based benchmarks and increases that of value stocks. As a result, early critics suggested it was simply a way to repackage value investing. However, the Fundamental Index has relentlessly outperformed traditional value indices, with the FTSE-RAFI All-World beating the FTSE All-World Value Index in 15 of the last 17 years.

When should investors increase their value allocations? My superficial answer would be: why not now, especially if they are already heavily invested in growth stocks? A more sensible answer would be to choose a more balanced mix of growth and value, or even take a value tilt, for all of the reasons above. Ask yourself if you are anticipating an alarm signaling the end of the growth bull market. If not, there is no reason to wait to adjust your portfolio.