Why are investors rotating into value stocks?

Rotations are a constant feature of the markets and the recent shift from high-growth momentum to value stocks has been a prominent event in the U.S. equity markets.

Value stocks are the ones which usually trade at a relatively lower multiple like Price to Book (P/B), Price to Earnings (P/E), Enterprise Value to EBITDA (EV/EBITDA) or just simply are at a discount to their intrinsic net worth, often known as the discounted cash flow (DCF) value. Growth stocks are usually the ones that have higher growth potential. Being relatively earlier in their industry life cycle, delivering a new technology or product can be a few reasons fuelling this growth, which is often reflected in the company’s sales or earnings number.

Value has underperformed growth for over a decade now. This can be observed through the valuation of sectors like financials, industrials, materials, etc. Growth stocks have outperformed every other factor over the years, the perfect example would be the FAANG (Facebook (NASDAQ: FB), Amazon (NASDAQ: AMZN), Apple (NASDAQ: AAPL), Netflix (NASDAQ: NFLX) & Google (NASDAQ: GOOGL). Sectors like technology and biotechnology comprise mostly of growth stocks and tend to trade at higher valuations. 

An important factor to consider here is the business cycle. Investors usually buy growth when the economy peaks as these are periods of technological innovation or disruption. Investors prefer rotating into value when we get to the end of the cycle as, during a bear market, lower valuation stocks tend to fall less than more expensive growth stocks and their higher-income offers a buffer for total returns. 

An average cycle may range from 7-10 years, the most recent cycle started after the 2008-09 crisis and is over-extended according to some analysts. 

Value often outperforms in the early stages of recovery. This has happened in almost every cycle and can be observed through the MSCI world growth vs value relative performance index. When the index is lower, value outperforms growth and vice versa. A big dip after the dot com bubble crash shows a rally in value, but the dip was relatively smaller in the 2008-09 slowdown.

The latest value rotation started mid-August 2019 when long-dated sovereign yields (>10-Year U.S. Treasuries) set their lows for the year. Smart beta ETFs, which track a particular style or sector, experienced $2 billion in inflows in Value ETFs in the third quarter and outflow of roughly the same amount in growth ETFs, which were trending early in the year.

Value ETFs like Vanguard Value ETF (NYSE: VTV) and The iShares Edge MSCI USA Value Factor ETF (CBOE: VLUE) are both up 3.5% in the last 6 months. Both of these closely track U.S. mid-cap and large-cap value stocks like AT&T (NYSE:T) — up 16% — Intel (NASDAQ:INTC) — up 30% — and Goldman Sachs (NYSE:GS — up 12.7%. The iShares value ETF (up 20% year-to-date) has also caught up with the iShares US Momentum ETF (CBOE:MTUM) which is up only 19% year to date. MTUM tracks high momentum US large & mid-cap stocks like Microsoft (NASDAQ: MSFT), Mastercard (NYSE:MA) & Visa (NYSE:V) and has grown substantially over the years.

Some investors believe that this is phase one and only 20% of rotation is complete, while others think that the rotation won’t last long as this represents traders covering for their short positions. What happens next in the U.S.-China trade war and the fundamentals of the global economy is important as better macro data and cycle recovery should drive the second phase of this rotation.

MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in the companies mentioned above. Read our full disclosure policy here.