Are value stocks due for a comeback?

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<p><strong>Christine Benz:</strong>&nbsp;Hi, I'm Christine Benz for Morningstar.com. Value investing has massively underperformed growth over the past decade. Joining me to discuss the perils and promise of this investment style, as well as to share a few value-leaning exchange-traded fund picks is Alex Bryan. He's Morningstar's director of passive strategies research in North America.</p> <p>Alex, thank you for being here.</p> <p><strong>Alex Bryan:</strong> Thank you for having me.</p> <p><strong>Benz:</strong> Alex, let's start by talking about the basic thesis behind value investing and why people think that it should work over time.</p> <p><strong>Bryan:</strong>&nbsp;Value investing is all about buying stocks that are trading at low valuations, low multiples of things like earnings, book value, and sales. It's based on the premise that stocks that are trading cheap should offer higher expected returns than stocks that are trading at higher valuations. That could either be because stocks that are trading at low valuations might be mispriced, investors might be overly pessimistic about those firms prospects, or investors might require higher expected returns to hold those companies as compensation for their higher perceived risk. But in either case, there's this expectation that low valuation should be predictive of future returns.</p> <p><strong>Benz:</strong> Let's talk about the sources of the underperformance over the past decade or even longer. Of course it's a complicated question, but can you unpack some of the main variables that have been hindering value stocks' performance?</p> <p><strong>Bryan:</strong>&nbsp;Value stocks have gone through a really rough stretch depending on which index you look at. They've all pretty much been out of favour for the past 10-plus years, and there's a few factors that are contributing to that. Number one, the valuation spread between value and growth stocks has increased considerably over the past decade. Value stocks are by definition going to trade at lower valuations than growth stocks, but that gap has only become bigger over the past decade, and that's a big part of why value stocks have underperformed. The second piece is the sector biases that are inherent in a lot of value strategies. Typically value-oriented indexes tend to overweight sectors like energy and financial services, and those have been particularly challenged areas of the market over the past decade, due to the decline in oil prices and the challenging interest-rate environment that we've had. They also tend to be underweight stronger-performing sectors like technology and healthcare, so those sector biases have taken a bite out of performance. Thirdly, a lot of growth stocks have exceeded the market's expectations as they've carved and deepened their economic moats over the past decade. So companies like Amazon and Netflix really, I think, have blown a lot of investors away. Even though a lot of people had high hopes for those companies 10 years ago, they've more than delivered on those expectations. So I think it's a combination of different factors, but anyway you look at it, value stocks have had a rough go of it.</p> <p><strong>Benz:</strong> Is there any reason to believe that the future will be different than the past?</p> <p><strong>Bryan:</strong>&nbsp;I think so. The valuation gap between value and growth stocks can't increase indefinitely. People have been saying that for a long time, but there comes a point when the valuation spread just can't grow any further, so I think that's something to keep in mind. You can't just look at the last 10 years and extrapolate that out indefinitely. But I think more importantly, the fundamental case for value investing really hasn't changed. While the valuations that we observed, based on things like price/book and price/earnings, may not necessarily be indicative of how a stock is trading relative to its intrinsic value, which we can't see, low valuations are still predictive of future expected returns. The lower valuations are today, the higher expected returns tend to be. And that's partially because you get more for your money when you a pay a lower valuation for a stock. Your dividend yields tend to be higher. You tend to get a higher buyback yield off of companies that are trading at lower valuations, and those are the fundamental areas of value creation. That's the cash flow that you're getting for the money that you're paying for those companies.</p> <p>At the end of the day, the fundamental case for value investing really hasn't changed. And I think it's important to keep in mind that valuation spreads between value and growth stocks really can't continue to widen out indefinitely. I think while value stocks should offer higher expected returns than the market, that doesn't necessarily mean that they're always going to outperform. Just like we expect stocks to offer higher returns than bonds, there's decade-long stretches when stocks underperformed bonds. The risk is real. This is not a free lunch. If you're not comfortable experiencing these potentially lengthy stretches of underperformance, you should probably just invest in a broadly diversified market-cap-weighted index fund and not tilt into value stocks. But I think if you have the fortitude to stick with it, value investing will reward investors over the long term.</p> <p><strong>Benz:</strong> Let's talk about some ETFs that you like for investors who maybe do want to play a resurgence potentially in value stocks. One strategy that you like is iShares MSCI Edge USA Value Factor ETF. Let's talk about why you think that strategy is attractive.</p> <p><strong>Bryan:</strong>&nbsp;This fund takes a sector-relative approach to stock selection. It's basically targeting stocks that are cheap relative to their sector peers, so it's looking at tech companies and comparing them against other tech companies, looking at banks, comparing them against other banks. And I think the sector-relative approach to stock selection makes a lot of sense when it comes to value investing, because there are important differences in companies across different sectors where you start to lose some information if you compare an energy stock against a tech stock, just because their balance sheets are very different, their business models are quite different. I think looking within each sector for value helps improve comparability of valuations. It also helps mitigate unintended sector tilts that you get with a traditional value strategy. With a fund like this, you're not going to get a big overweighting in energy, or a big overweighting in financial services. It's going to give you sector weightings that look a lot like the market. And I think that's really important, because most of the value from&nbsp; value investing has come from stock selection, not necessarily the sector biases that come along with value investing.</p> <p><strong>Benz:</strong> For investors who are maybe even more contrarian and want to play a deeply unloved part of the market, Vanguard Small-Cap Value ETF is one that you like. Why do you like that one?</p> <p><strong>Bryan:</strong>&nbsp;Historically, value investing has tended to work the best among the smaller stocks. I think there's a few reasons for that. One, small-cap stocks are less widely followed than large-cap companies. So there might be a greater potential for mispricing, and more stocks in that area of the market could become undervalued. Those stocks are also riskier, so they might offer some compensation for that risk. But if you're comfortable with those risks, I think this is a really good way to get exposure to this area of the market. This Vanguard fund basically targets stocks that represent the cheaper half of the U.S. small-cap market, and weights them based on market capitalization. So what you end up getting is a very well-diversified portfolio that really gives you targeted exposure to this area of the market that has been beaten up quite a bit. And I think if value has a comeback, this particular fund will be one of the better performers out there. This is also one of the cheapest small-value funds available. And as we all know, low fees are one of the best predictors of future performance.</p> <p><strong>Benz:</strong> Alex, it's always great to get your insights. Thank you so much for being here.</p> <p><strong>Bryan:</strong>&nbsp;Thank you for having me.</p> <p><strong>Benz:</strong> Thanks for watching. I'm Christine Benz for Morningstar.com.</p>

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