Market report May 2021
After many difficult years, value equities have risen to prominence. Since November 2020, the MSCI World Value Index has risen 33.2 percent, beating growth equities by a wide margin. Investors in a variety of economies, from Japan to Europe to the United States, have rediscovering the allure of cheap equities, which are sometimes the subject of debate.
Chart: Rates of return stocks 01.11.2020 – 30.04.2021, different investment style included:
Past performance and current analysis do not guarantee future results, Global represented by MSCI World Value Index and MSCI World Growth Index. US represented by Russell 1000 Value and Russell 1000 Growth. Europe represented by MSCI Europe Value and MSCI Europe Growth. Japan represented by TOPIX Value and TOPIX Growth. Emerging Markets represented by MSCI Emerging Markets Value and MSCI Emerging Markets Growth. As of April 30,2021
Source: Bloomberg. FactSet, FTSE Russell, MSCI, S8P, Tokyo Stock Exchange
When opposed to growth companies, value equities have historically traded at a discount. By the end of 2020, the MSCI World Value Index was 53% cheaper than the MSCI World Growth Index (chart) in terms of price/forward earnings. That is roughly double the 28 percent average discount that global value stocks have traded at since 1997, and it is a bigger discount that the dot-com bubble peaked at in 2000.
Chart: Discount, value stocks are quoted in relation to growth stocks, global approach (MSCI World Value Indexes vs MSCI World Growth Index Prlce-to-Forward Earnings Discount)*:
Past performance and current analysis do not guarantee future results. * Price to forward earnings (next 12 months) since January 1997 Through April 30,2021
Source: FactSet, MSCI, Thomson Reuters l/B/E/S
The underperformance of value was common. By the end of 2020, value equities were cheaper than growth stocks in areas as broad as consumer durables, healthcare equipment, and telecom services than at any point since 2001. The same was true for value equities in the majority of large regional markets. Even with the current rise, the value-to-growth ratio remains extraordinarily low. By the end of April, the MSCI World Value index was still trading at a 51 percent discount to the MSCI World Growth index, considerably below the 28 percent long-term average. And, across industries and regions, the discounts have only shifted marginally away from the historical highs reached at the end of 2020.
As experienced value investors are well aware, inexpensive stocks can get much cheaper, and severe discounts may indicate a value trap. A stock may be inexpensive because the company’s earnings have been permanently harmed. Deep reductions pose a problem for investors. Do they indicate a new and irreversible truth that investors are missing, namely the impending demise of value investing? Or do these discounts reflect pent-up performance in value stocks, which may indicate exceptional recovery potential when market conditions change?
As economic growth accelerates and broadens, while visibility into post-pandemic behavior improves, value profits and multiples should gain. As a result of these changes, asset allocators may allocate more funds to value portfolios. Interest rates might be normalized from their historic lows and put downward pressure on the multiples of growth stocks, which tend to benefit from reduced interest rates. Market conditions have produced a once-in-a-lifetime rebound opportunity for investors ready to start or grow allocations to value companies now. Indeed, several value firms reported excellent profits growth in the first quarter, so even as share prices rose, their P/E multiples remained appealing.
Passive portfolios and their growing popularity. Is there any risk hidden?
If the favorable climate for firms deteriorates, concentration risk may become a significant burden. While the investing climate has been favourable to generating outsized gains for a select few equities, what happens if the favorable environment in which these firms operate deteriorates? Concentration risk develops when exposure to a single stock, industry, or style becomes excessive in comparison to the rest of a portfolio or index. It occurs when supervision fails or the investing process lacks a sufficient rebalancing mechanism. As concentration has increased, vigorous performance has been fuelled mostly by narrow leadership among a few companies. Over the previous several years, the five largest US stocks have grown to account for a growing share of the total market, more than doubling from 11 percent in 2017 to 22 percent in 2020.
Chart: Concentration and its correlation of the US stock market
As 01 April 1,2021
Source: FactSet and S&P
At the growth benchmark, the giants are heavier and the concentration is even sharper. The 5 largest stocks in the Russell 1000 Growth Index accounted for 36% of the benchmark at the end of March. Market concentration continues to increase, and passive funds have disproportionate exposure to these stocks, making a high-end investment portfolio. The common factors underpinning the collective success of today’s leaders are primarily the benefits of falling interest rates and network effects platform business models, as well as the “winner takes all” competitive dynamics. These distinctive business models have contributed to a virtuous cycle of continued expansion and appreciation from the M&A. Some signs may point to a tipping point on the horizon, which can cause problems for highly concentrated passive portfolios.
Interest rates have begun to rise. The 10 U.S. Treasury bond yield rose by 72 basis points from the beginning of to the end of April. The stocks that have recently succeeded may be the most vulnerable to this move. That’s because the value of the stock is determined by the present value of its future cash flow. And because fast-growing companies depend on the cash flows they generate in the future, the drop in discount rate disproportionately benefits growth stocks. However, the reverse is also true.
The other thing is the fact that the big tech companies are riding the wave of corporate effects that pushed their shares higher, but now they can become victims of their own success. Their size makes them a target for strengthening regulatory overhaul because lawmakers fear that the power of the monopoly will stifle competition and give control to a few people. In October of last year, taking as an example, the United States Congress issued a report on the monopoly by large technology companies, calling for the strengthening of antitrust laws and the adoption of new regulations to reduce the power of dominant companies.
Different companies face different risks of rising interest rates, and regulation will not have the same degree of impact on all large technology companies. For example, companies that rely on acquisitions for growth may be significantly affected by the stringency of regulations. Organic growth may not be enough to support these giants. The loss of acquisition will not only reduce your growth potential, but also limit your ability to deploy capital and drive returns. Active managers can weigh this risk and position their portfolio to reduce risk exposure, but would the passive strategy be able to act smoothly and adapt to the situation?
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The views expressed in this document do not constitute research, are not investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time.