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THE GREAT STOCK ROTATION OF 2021: Is Value Investing Back?

Delwin Graham - Mar 31, 2021
What was working in 2020 doesn’t seem to be working in 2021. Value stocks, that is, “cheaper” stocks like banks and energy firms, have greatly outperformed fast-growing stocks such as the big tech names in 2021 so far.

What was working in 2020 doesn’t seem to be working in 2021. Value stocks, that is, “cheaper” stocks like banks and energy firms, have greatly outperformed fast-growing stocks such as the big tech names in 2021 so far. As of March 15, 2021, the MCSI World Value Index is up 8.7 percent, year to date, compared to a 0.04 percent fall in the MSCI World Growth Index. In Canada, stocks like the Royal Bank (RY:TSX) and Suncor (SU:TSX) are beating Shopify (SHOP:TSX) and Lightspeed (LSPD:TSX).

Value investors say that the world is coming back to its senses. Value investing seeks to invest in companies that are undervalued relative to the market. Valuation can be measured in a number of ways, including price-to-earnings ratio and price-to-book ratio. In contrast, growth investing aims to invest in companies that are rapidly growing revenue, earnings, and cash flow. As a result, they often appear overvalued based on valuation metrics.

When COVID-19 hit the world in early 2020, it forced a transition to working from home, and a general panic gripped the population. The stay-at-home economy set up a trend where certain sectors would benefit, and others would not. For example, energy and commercial real estate experienced significant downside pressure, while technology and healthcare saw tremendous upside growth.

The optimism that accompanied the news about vaccines in November has led many to wonder if this will be the catalyst for an investment-style rotation. Specifically, the idea is that the prospect of returning to normalcy will allow the market to look forward again, and this will have a positive effect on the value style because the cheapest stocks in the market at the moment can be found in the cyclical sectors, like materials and chemical manufacturers. Technology and healthcare companies require massive amounts of raw materials in order to build and supply finished products to the markets, and the rise of the underpriced commodity sector is inevitable.

For many, the triumph of the value trade is inevitable. According to conventional investing wisdom, value stocks will outperform growth stocks over the long run. There certainly seems to be historical evidence for this claim. Since 1926, value investing has returned 1,344,600 percent, according to the Bank of America. During that same time period, growth investing returned just 626,600 percent. (Cf., Rob Berger, “Do Value Stocks Really Outperform Growth Stocks Over the Long Run?”, www.forbes.com, November 12, 2020)

But more recently, growth investing has substantially outperformed value investing. Over the past decade, the Russell 1000 Growth Index has returned 17 percent annually, while the Russell 1000 Value Index has returned just 10 percent. (Cf., Berger, Do Value Stocks … ?)

Is this outperformance of growth an anomaly? Some analysts think so and see 2021 as the year of a rotation to value. In fact, what they envision is a repeat of the crash of the highly popular Nifty Fifty stocks in the 1970s or the burst of the dot-com bubble in 2000. After having been bid up by “irrational exuberance” of investors, overpriced growth stocks will then revert back to the historical mean of their performance – that is, they will undergo a brutal correction. The market will correct itself. (Richard Halle, “Strategy: Is 2021 Going to be the Year of a Value Rotation?”, www.next-finance.net, February 8, 2021).

But what if it’s different this time? Value investing is about acquiring stocks at a valuation below how much they are worth. How this is done has differed over the years. Benjamin Graham, often considered the founder of value investing, was looking for stocks of companies that were trading below a conservative estimate of their liquidation value – that is, less than their book value. Warren Buffet broadened the notion of value investing by looking for stocks that traded below their “intrinsic value”, which includes high-quality companies that could reinvest large amounts of capital at high returns. He looks for companies with large moats to protect this reinvestment opportunity. (Cf., Jeff Henriksen, “The Great Value Rotation: A Revival in the Performance of Value Stocks Masks an Evolution in the Storied Investment Strategy”, www.forbes.com, March 4, 2021)

Perhaps the Information Age has made obsolete the notion that value investing is searching for mispriced stocks by looking at GAAP accounting data. Any computer can find a stock that is cheap on a price-to-book basis. Exploiting mispricing might depend on business analysis rather than statistical metrics. To this point, Warren Buffet famously said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Of course, determining a “wonderful company” is no easy task; it requires sharp business analytical skills – that is, individual knowledge and experience or ‘talent’. And so, the information age has ushered in the age of the stock picker, and the differentiation between growth and value is blurring – growth at a fair price. The likelihood that the performance of value stocks in 2021 will revert closer to their historical mean (which is a good thing) should not begrudge the possibility that growth stocks will continue their trend up (which is also a good thing); it’s not a zero-sum game. Please contact me at dgraham@cgf.com or 780-408-1518 for a few win-win stock picks of my own.