Goldman Sachs: Value Investing Could Revive on Fed Cuts

A shift to strong performance for value stocks could be ahead if the right conditions form, Goldman Sachs said in a note.

After years of underperformance, value stocks would get a boost upward from a cut in interest rates, which the investment firm believes is increasingly likely. Though the Federal Reserve left rates unchanged at its meeting last week, Goldman Sachs analysts expect two cuts of 25 basis points each in July and September, Goldman’s chief U.S. equity strategist David Kostin said in his Weekly Kickstart report Friday.

Many investors have looked for a return to value outperformance after the class lost to growth stocks for an extended period. For the past 10 years, the Vanguard Value ETF (VTV, Financial) has returned an average of 12.85% annually, compared to an average return of 15.07% per year for the Vanguard Growth ETF (VUG, Financial). In the past three years, the gap was even more pronounced, with the value ETF returning 10.01% and the growth ETF delivering 13.78%.

The Fed’s monetary easing trigger an advance in value because a disparity in price-earnings ratios between growth and value stocks typically indicates “strong value returns” only if investors expect accelerated economic growth. Currently inexpensive stocks are trading at a 65% discount in price-earnings ratio to expensive stocks, or 10x versus 28x, their fourth-lowest percentile relative to the past 35 years, Goldman Sachs said. Software stocks, by contrast, trade an average enterprise value-sales multiple of 6, near their highest besides the Tech Bubble.

A rotation to value stocks would require investors to “expect a sustained acceleration in economic growth,” though the Fed’s actions have not brought that about yet.

“Dovish monetary policy has buoyed the stock market in recent weeks, but has arguably done little to lift equity market expectations for economic growth,” Kostin wrote. “Cyclicals have lagged defensives and growth stocks have continued to outperform since the FOMC meeting. The two most recent episodes of value stock outperformance were during the ‘reflationary’ period of 2H 2016 and ahead of the passage of the corporate tax reform law during late 2017. Both of these periods were characterized by a surge in investor economic growth expectations.”

To take advantage of the potential shift to value, Goldman recommended investors buy stocks with a “quality overlay.” It compiled a portfolio of 50 stocks with the highest prospective Sharpe ratios, including laggards with “value tilts.” The median stock included lagged the S&P 500 index by 13 percentage points and has a 31% price-earnings ratio discount.

Goldman expects the average basket stock to return 23% over the next year, significantly higher than 7% return it expects for the typical S&P 500 stock. Stocks in the basket with the highest earnings-related upside to consensus target prices are:

• Western Digital (WDC, Financial): Expected return, 32%
• Qualcomm (QCOM, Financial): 22%
• Halliburton (HAL, Financial): 64%
• Marathon Petroleum (MPC, Financial): 58%
• Salesforce (CRM, Financial): 16%
• Facebook (FB, Financial): 17%

GuruFocus data shows that the FPA Capital Fund (Trades, Portfolio) has wagered the most of tracked investors on Western Digital, with 7.9% of its equity portfolio invested in the stock. Jim Simons (Trades, Portfolio)’ Renaissance Technologies has the largest overall position, claiming 0.98% of shares outstanding. Jerome Dodson (Trades, Portfolio)’s Parnassus Endeavor Fund (Trades, Portfolio) has the most assets dedicated to Qualcomm of investors GuruFocus tracks, at 3.48% of the equity portfolio. Primecap Management has the largest holding, with 2.03% of shares outstanding.

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