The second half of 2016 represented one of the best periods in history for value investors but even after this there was still plenty of reason to believe value would continue its run into 2017. But we, along with many others, were caught off guard. Structural headwinds struck and value stalled.
Low oil prices, increased competition and regulatory pressure weighed on the energy and telecoms sectors respectively which collectively make up over 20pc of the value index. Moreover, bond yields didn’t remain on their upward trajectory making it particularly difficult for financials to perform in this kind of environment.
But, one year on, it definitely feels like we’re on the cusp of a step change for value investing. We’re beginning to see a reversal in some of these structural headwinds.
The energy sector has been outperforming for the past few months, predominantly down to higher oil prices, and we’re starting to see bond yields move higher. Should both these trends endure, all else being equal, value should start to outperform again.
Value remains at depressed levels – close to 60% below its 2006 peak, so there’s plenty of scope for value to catch up, with several factors helping to reinforce this catch up.
Firstly, value dispersion remains wide. Dispersion refers to the valuation gap between cheap and expensive stocks. The relative valuation between value and growth indices remains pretty extreme – within the widest quintile versus history, see chart below.
It’s important to point this out because, again, all else being equal, it’s predictive of value’s future performance.
Secondly, not only does wide value dispersion currently exist between sectors but, perhaps just as crucially, within sectors too. For example, the automobiles sector currently offers a forward P/E of 7x versus software & services which is on 20x. Within automobiles, Fiat is currently on a forward P/E of 5x versus Ferrari on 31x. Today’s dispersion within sectors is wider than it was in the summer of 2016 which preceded the start of a strong value rally.
With value at such depressed levels relative to its own history plus this wide dispersion, which tend to be a driver of value’s performance, we expect to see a narrowing of value gaps both between and within sectors.
Others reasons to believe change is afoot
Generally, value stocks are unloved companies which may have structural headwinds and regularly disappoint the market with their earnings announcements. Hence why they trade at a cheap valuation. But, right now, we’re witnessing that the vast majority of value sectors are seeing earnings upgrades and beating market expectations on a quarterly basis. On the flip side, we’re starting to see a number of growth sectors starting to struggle a little resulting in downgrades.
If current trends continue, value style investing in Europe may be poised for a comeback after its stalling in 2017. After the longer term dominance of growth investing this may prompt investors to rethink their investment strategy and sector exposure.
Ian Butler (pictured above) co-manages the JPMorgan Funds – Europe Strategic Value Fund (SICAV) at JP Morgan Asset Management.