Understanding Value’s Recent Struggles
Value investing has received a lot of negative press and scrutiny and much of it has been well deserved given performance struggles. Value underperformance has occurred up and down the market cap spectrum and across both developed and emerging markets, however, it has been most pronounced in the U.S. large cap space where the dominance of mega cap Information Technology companies has been the most significant. You can see from Figure 1 that the Russell 1000® Value has underperformed the Russell 1000 Growth® by a cumulative 233% over the last 10 years.
Value’s initial struggles started around the time of the Global Financial Crisis about 12 years ago. There have been fits and starts for value over that period – for example Value’s strong performance in 2009 and 2016 – but in the fullness of that 12 years, performance has been mediocre. That said, the real significant performance issues for value investing occurred over the last 3 years, with the global pandemic acting as an accelerant for relative weakness.
However, when you expand this time period to 20 years, relative results look quite different. Despite recent underperformance, long-term results for value are still competitive. In fact, up until a couple of years ago, the Russell 1000® Value was still outperforming the Russell 1000 Growth (Figure 2).
Value’s underperformance is not the entire narrative. Figure 3 details the performance of various other factors over the last 10 years. You can see the story is also about U.S. Large Cap Growth outperforming everything else, including small caps, developed international, and emerging markets. This narrow trade has been the winning investment for quite some time now given the outsized impact the FAANG+M (Facebook, Apple, Amazon, Netflix, Google (Alphabet), Microsoft) companies have had on markets.
What has been driving these outcomes? First, we have been going through a technological revolution and the result has been growth companies delivering on fundamentals. In Figure 4, we plot the free cash flow of the technology sector along with its enterprise value. While the value of the sector has dramatically increased, so has its free cash flows, which helps justify its higher valuations.
Another part of the story is loose monetary policy with falling interest rates since the Global Financial Crisis. Low rates negatively impact value investing in a variety of ways.
- First, traditional value industries like Banks and Insurance companies are disproportionately hurt by lower interest rates.
- Second, growth companies are valued based on their cash flows in the future. Lower interest rates mean a lower discount rate, making those future cash flows more valuable. This props up the valuation of growth companies relative to value companies, whose valuation is more dependent on the current, existing business and near-term cash flows.
- Third, low interest rates make borrowing cheaper for lower quality companies. The result is that these lower quality companies are artificially kept alive leading to more and more “zombie” companies (Companies that earn just enough money to continue to operate but may be unable to pay off debt and are considered close to insolvency) out there. In a normally functioning market, the capital cycle would take hold. Creative destruction would occur, and the weaker companies would go out of business while the stronger companies survive leading to consolidation and improving fundamentals for the surviving companies. We believe low interest rates are interfering with this normal course of creative destruction.
The impact of the pandemic has also created challenged conditions for typical value companies which are generally more exposed to the real economy whereas much of the growth index is comprised of the digital economy. It is those technology companies that have benefited the most from lockdowns and social distancing.
The pandemic has accelerated the digitization of customer interactions by several years across all markets. An open question is how much of this was simply a demand pull forward vs. a permanent structural change. We believe that the truth lies somewhere between the two. We believe there are some secular, structural shifts going on, but demand was also clearly pulled forward due to COVID and now these companies have lofty growth expectations that may be difficult to meet going forward.
Legal Notices & Disclosures
The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only.
The information provided in this presentation should not be considered as a recommendation to purchase or sell a particular security. The weightings, holdings, industries, sectors, and countries mentioned may change at any time and may not represent current or future investments.
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Past performance is no guarantee of future results.
The information shown relates to the past. Past performance is not a guide to the future. The value of an investment can go down as well as up. Investing involves risks including loss of principal.
The Russell 1000® Growth Index is an unmanaged index generally representative of the U.S. market for larger capitalization growth stocks. This unmanaged index does not reflect fees and expenses and are not available for direct investment. The Russell 1000® Growth Index and Russell® are trademarks of Frank Russell Company.
The Russell 1000® Value Index is an unmanaged index generally representative of the U.S. market for larger capitalization value stocks. This unmanaged index does not reflect fees and expenses and is not available for direct investment. The Russell 1000® Value Index and Russell® are trademarks of Frank Russell Company.