The ability of humans to adapt is often ignored in the hype of the headlines. Despite the fact that the pandemic is still disrupting through different variants shutting places down again as well as stretching supply chains, people will adjust to these changes and life will move on.
What then does the future of investing hold if we would like to ignore the headlines and place our wagers based on a return to a more “normal” routine and way of life? Well a new paper thinks that this will involve greater returns in sectors that have gone unloved for some time: foreign and value stocks.
It’s been no secret that the performance of emerging markets, value stocks and their related sectors have been terrible since the financial crisis. I have called on emerging markets to outperform for years at this point and continually been disappointed. Yet through the underwhelming performance there are signs of life that a new renaissance in these sectors could be around the corner.
Valuations
In a a paper published by Research Affiliates, the authors point to the fact that value stocks are at one of their lowest discounts ever compared to the rest of the market and when this happens a revision is usually soon to follow.
In the Spring of 2020 and in the wake of the Covid shutdowns, tech stocks were ruling the market. People were stuck home and many relied on technology to get them through the worst of the pandemic. Many of us stayed home and ordered food from Grub Hub, ordered household items from Amazon and watched shows on Netflix to pass the time. Cloud computing and cyber security for white collar work became more important than ever with work from home and many large “old economy” companies became dependent on the infrastructure offered by big tech. It made sense that the valuations of big tech therefore increased in anticipation of greater profits from the pandemic period. There was also a string case that higher profits would continue even after the pandemic as work from home became much more common.
Although work from home was initially considered an anomaly (and still is an anomaly for many) a hybrid setup for some roles and even fully remote roles for others seems set to be the norm going forward. This would seem to point towards a new paradigm in regards to the place tech has in our daily lives as well as how it should be valued.
Yet as we saw last October when value shares and the overall market surged, the re-opening trade saw fantastic returns in many of those “old economy” stocks like airlines, banks and energy companies. As we moved into 2021 it was widely expected by many that these sectors would continue to outperform. With the emergence of the Delta variant however, a full reopening was put on hold, yields again fell and tech once again surged in value.
Yet this may have been just a bump in the road towards the overall momentum that is shifting towards value stocks. Tech growth is an easily sold story. Exciting new technologies which can capture costs savings and new revenue streams offer optimistic stories for investors that are more than willing to convince themselves that they are the first wave into a new company or sector offering enticing returns. Yet when everyone is doing this over the course of a few years it can lead to over optimism and overvaluation.
In fact, this is what Research Affiliates finds explains the underperformance of value shares since 2007. Value stocks, just by definition always trade at a discount to growth stocks. They include those companies that trade at a low price to sales, low price to book value or low price to earnings. Yet the level of that discount to growth stocks has varied widely over time as can be seen below.
Prior to 2007, value had been beating the overall market and was in the upper quartile of valuations compared to growth. What that means in layman’s terms is that on a scale of 1 to 4 with 4 being the most expensive, is that value stocks were at a 4. Since then however, value has fallen to a 1. Not just the lower range but in fact the cheapest it has ever been relative to growth historically.
The authors point out that earlier in the year, when yields were climbing (as they are now), value handily beat growth and both foreign and emerging markets shot up much more than their peers in growth. The intervening time since this past March saw a pullback in this but the authors expect it to resume as things normalize further.
So Where Would Growth Come From?
The authors looked at the discount for value shares to growth across the US developed and emerging markets and found that almost all markets except for Australia had historically rare discounts for value shares. This is driving their expected return predictions over the next 10 years to favor heavily sectors like emerging market value, EU value and yes, even Japanese value shares, which are actually quite reasonably priced long after the 1989 stock market bubble popped.
Notice that the only US sector expected to have any significant growth is the value sector. The authors did break out small cap equities but left out sub sectors that could be interesting as well such as small cap value and mid cap value.
Personally, I am positioned across all these sectors for an eventual flow back into value with mid-cap and small-cap indexes potentially offering enhanced returns for small investors compared to their large cap peers. I do this through Vanguard index ETF’s such as VBR, VOE and VTV. In addition to these, I hold an emerging market ex-China ETF (EMXC) as well as an international small cap ETF (VSS). I previously held an international value index fund (EFV) but felt this was doubling up on some exposure I already had to the UK in particular which I have through my international small cap fund. I also hold an index fund tracking the UK market on a short term valuation as well as sterling appreciation basis which also worked out well in the beginning of the year.
Yet the study points out potential areas where myself and many investors may be lacking some exposure. That area for myself is the emerging market value sector. This sector has performed so poorly compared to even overall emerging markets over the past decade that there are very few if any ETF’s specifically covering the sector. Two candidates that stand out currently are the WisdomTree Emerging Market High Dividend Yield ETF (DEM) as well as the iShares Emerging Market High Yield ETF (DVYE). The former is currently yielding 4.48% and the latter an unheard of 6.42%. To put this valuation in perspective, the high yield bond ETF is currently yielding 4.44% and the iShares Preferred Share ETF is yielding 4.47%. In an environment hungry for yield with rock bottom rates, it seems odd that investors continue to ignore the obvious opportunities in these sectors.
And this is just on a yield basis. High yield bonds and preferred shares have little upside where any perk up in emerging markets, be it from increased domestic demand post pandemic, appreciating currencies due to the massive government spending we have seen in the past year, or a shift into higher yielding value and international stocks by investors could offer rocket fuel to these investments while tech struggles due to its high valuations.
There are some signs this may be happening already with JP Morgan predicting Robinhood shares may fall 20% as meme stocks fades, leaving it dangerously exposed to crypto for revenue. If demand for crypto also shifts, a number of tech firms could also be in trouble.
Long Term Perspective
Just as it took guts to invest in Apple when the P/E was around 14 a few years ago and many asked what was next for the company, it will take some fortitude for investors to take some positions in these areas and patiently wait to realize returns.
I was reminded of this when I read a an Instagram user share the story of lesser known former Berkshire partner Rick Guerin. Guerin owned a significant stake in Berkshire in the 60’s and 70’s but unlike Buffet and Munger, Guerin wanted to speed up the process of getting rich so he leveraged himself up. In the bear market of 1973-1974, Guerin’s partnership lost 62% of its value and he was forced to sell shares of Berkshire back to Buffet for $40 a share. Those shares are now worth $413,000 each. Guerin likely missed out on becoming a billionaire by being impatient. It’s an important lesson to learn for those complaining that spectacular returns are still eluding some segments of their investment, think of Guerin when you look at today’s market.
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