The rotation to value stocks continued in February, which was also reflected in the substantial growth of the HCP Quant Fund. HCP Quant returned +11.02% during the month. The benchmark index MSCI ACWI SMID Value Total Return also grew by +6.60% in euros. The United States’ S&P 500 Total Return Index, which measures the development of large-cap equities, returned +3.20%, and the European equivalent S&P Europe 350 +2.73%.
In hindsight, it is easy to pinpoint the catalyst that changed the markets to favor value stocks again. It was the long-awaited news about an effective corona vaccine. Pfizer was the first to announce the news in early November, and since then HCP Quant has returned 34%.
The stock market tends to price in events around six months into the future. Value stocks’ “relief rally” is happening because investors have begun to look at the time after corona vaccination. A return to the norm. Many of the hardest-hit stocks have been the biggest gainers of the new cycle. Even after the recent surge, many of them are still valued very low, and when compared to their average historical valuations, there is still plenty of room to grow. If the rotation is here to stay, it means better times for value investors. And it will also greatly benefit HCP Quant.
There are also a number of factors that could cause an early end for the rotation. At the current pace of vaccinations, in most countries, we are still many months away from returning to normal life and as such, the turn in favor of value stocks may have begun too early. In this case, we might still be facing bumps in the road until the timeline gets clear. On the other hand, the valuations were very low, to begin with.
The other large risk factor to the new rotation is the actions of central banks, as they have the difficult task of balancing sufficient inflation, interest rates, and the revival of the economy. Low interest rates and high levels of quantitative easing favor growth stocks, whereas higher inflation and interest rates favor value stocks. Interest rates turning higher has been supporting value stocks recently. Yesterday the President of the United States Joe Biden signed a record-breaking 1.9 trillion-dollar COVID relief bill. While stimulus funds like this mainly support growth stocks, there is a limit to how much new money can be pushed into the system without causing uncontrollable inflation.
In other words, there are some dark clouds looming over both growth and value stocks. If previously investor’s portfolio has had a focus on growth stocks, now might finally be time to allocate some of it into value stocks. Similarly, those who are “all-in” on value stocks could benefit from also holding a portion of growth stocks, as even if the rotation has begun, we are still in its early phases and a lot can still happen.
The past couple of years have been a strange time for investors. There have been many ways to underperform, but there has really only been one way to outperform: mega-cap growth stocks. What makes this so extraordinary, is that typically excess returns are spread among a number of factors, whereas in recent years there has essentially been only one way to do it. By investing in the largest growth stocks.
David Blitz from Robeco Quantitative Investments wrote about the returns of these different factors in his research paper: The Quant Crisis of 2018-2020: Cornered by Big Growth. Blitz covers the traditional academic factors: size (small-minus-big, SMB), value (high-minus-low, HML), investment (conservative-minus-aggressive, CMA), profitability (robust-minus-weak, RMW), and momentum (winners-minus-losers, WML). Without the momentum factor, the rest of the factors combined made a loss during the past decade.
In the end, Blitz concludes:
“We examined the performance of factor strategies during the Quant Crisis of 2018-2020. Our main finding is that there was basically only one way to outperform during this period, namely by investing in the largest and most expensive growth stocks. Mega-caps with the strongest profitability and momentum characteristics also outperformed, but we find that this is due to their sizable implicit exposure to the same large growth stocks. Moreover, profitability was only effective in the mega-cap space conditional on having a strong growth tilt. Smaller stock portfolios underperformed across the board. Thus, there were numerous ways to fail during the 2018-2020 period, but essentially only one way to succeed.“
“In fact, Arnott et al. (2020) and Blitz and Hanauer (2021) have observed that the recent underperformance of the value factor is primarily driven by an extreme multiple expansion of growth stocks which appears unsustainable and bound to mean-revert, at some point. In other words, instead of having been arbitraged away, the value factor has experienced an increase in its expected return to a level well above its historical average.“
The valuation multiples of growth stocks have been stretched to unsustainable levels, and correspondingly, the expected earnings of value stocks are considerably higher than historical means.
Value investing isn’t dead after all, even though many had already accepted its passing.
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HCP Quant Portfolio Manager
“The single greatest edge an investor can have is a long term orientation.”