Turnaround for Value Investing Likely to Begin in 2016

Many value investors underperformed as the market soared over the past several years, but the tables may soon turn for quality, large-cap, liquid stocks, Bank of America Merrill Lynch Global Research analysts said this week.

“These days, value investing has been replaced by a preference for ‘growth at any price.' But over the very long term, Value has outperformed Growth,” the analysts said, heralding the “return of value investing” in the Dec. 8 report, “2016 Year Ahead Outlook.”

Many value funds tracked by GuruFocus felt the heat from the market’s trend toward growth stock in recent quarters and commented on it in their shareholder letters. Third Avenue Value Fund, chaired by Marty Whitman, for instance, realized a 3.64% decline for fiscal year 2015. Its managers watched a handful of large-cap growth stocks command market attention, regardless of business soundness, while interest in companies facing short-term headwinds waned, they said.

“This chart reminds us of other periods where value investing moved out of favor for the short term, such as the 1997-2000 tech bubble and the 2005-2007 housing boom where growth optics trumped tried and true measures of valuation,” Lead Portfolio Manager Chip Rewey and his associates wrote in their fourth quarter letter to shareholders.

Rewey referred to a chart of one-year performance for growth and value indexes. For the year ended Oct. 31, the Russell 3000 Growth Index returned 8.72%, compared to 0.24% for the Russell 3000 Value Index.

Like most die-hard value houses, the short-term underperformance did not deter it from its fundamental strategy, however.

“We readily acknowledge that it can be frustrating to stand apart from the herd and post investment returns that trail the flavor of the day in times where the market has little regard for our philosophy… This sort of volatility is the friend of the patient investor.”

Other widely value funds similarly declined this year. The Yacktman Fund (Trades, Portfolio) traced down 9.95%, the FPA Crescent Fund fell 4.73% and the Oakmark Fund slid 5% for the fiscal year ended Sept. 30, versus a 5.29% declined for the Standard & Poor’s 500 Index.

Donald Yacktman (Trades, Portfolio) also affirmed his long-term strategy in his third quarter letter. “Under a similar set of circumstances in the late 1990s, a period of underperformance set up exceptional outperformance over the long term,” he wrote.

The BofAML study listed several reasons its analysts believe, similar to Yacktman, a turnaround for value is due in 2016, beginning with the profit cycle. Frequently, growth tends to win over value when profits slow, as seen in 2015, and the opposite happens when profits accelerate. BofAML expects solid growth in profits in 2016, as two factors that weighed on them in 2015 mitigate: the strengthening dollar and low oil prices.

Based on their research, a 5 percentage point or greater increase in profits has historically been accompanied by value beating growth 71% of the time, by 7 percentage points on average. Over the next year, their research forecasts a 5 percentage-point pickup in earnings.

“And encouragingly, a number of valuation factors trade at or near their cycle trough valuations: Low P/E (trailing and forward), High FCF/EV and Low Price/Sales all appear to be trading at as much as 40% discounts to the overall market, and well below their relative multiples over the last five years,” the report authors said.

Strategists also urged investors to choose stocks over sectors, as sectors should face an abundance of macro risk, disruptors, negative headline risk or were overbought or too expensive. Sectors further arbitrarily classify stocks, they said, highlighting the need to analyze companies and themes individually, a value investing practice.

The report authors were upbeat about another favorite of value investors, high quality stocks. They expect them to perform well not just for the next year, but the next decade. Quality stocks tend to outperform amid increasing volatility, they found, such as in the third quarter.

“We expect volatility could return as the Fed embarks on its first tightening cycle in a decade, and a pick-up in volatility is also suggested by the yield curve (which has historically been a good long-lead indicator of the VIX),” the report authors wrote. “And from a factor perspective, we found that post-momentum runs, quality factors tended to outperform.”

As much as the report agreed with many value gurus’ expectations of better days ahead for the style, it differed on expected returns for the overall market. BofAML expects the S&P 500 to reach 3500, including 2% dividend yield, for the next decade, producing an annualized return of 6%.

The Buffett indicator, as calculated by GuruFocus using the ratio of total market cap over gross national product (GNP), implies an average annual return including dividends of 0% over the next eight years.

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