Early Days in the Value Recovery

First Quarter 2021 Commentary

For Financial Advisor Use Only

Printable Version

Pro-value cycles have historically been long and durable. The evidence suggests we are in the early stages of what may be a powerful period of value outperformance.

HOW LONG WILL THIS VALUE CYCLE LAST?

Since mid-2018, economically sensitive and cyclical names have been hard hit by uncertainty stemming from the trade war, falling interest rates, and late cycle fears. The disparity in valuations between these shares and large technology stocks was turbo charged last spring by investors reacting to the pandemic, resulting in historically high valuation dispersion. News of an effective vaccine in November finally gave the market visibility to a path out of the pandemic, and the outperformance of value stocks since then has been significant.

This pattern of behavior is not new. Value typically underperforms going into a recession when there is uncertainty around the severity and duration of economic impact. For the disciplined value investor, these darkest periods – when sentiment is lowest – provide the opportunity to plant the seeds for outperformance through fundamental research. Once fears give way to facts, the companies cast out of favor re-rate, and in fact become momentum stocks themselves.

As this scenario plays out yet again, investors find themselves asking the following questions:

1. How long will the value rally last?
2. How much more can value stocks outperform after such a steep rally?

While there is no way to answer these questions with certainty, history suggests that there is plenty more to come.

VALUE CYCLES ARE LONG AND ENDURING

Reviewing value cycles of the past 50 years helps put the recent period into context (Figure 1); the recent outperformance of value appears to be nascent compared to history. On average, pro-value periods have lasted 62 months and delivered 138 percentage points of outperformance. This compares to 6 months and 39 percentage points thus far this cycle.

Figure 1: Pro-Value Periods over the Last 50 Years

Source: Sanford C. Bernstein & Co., Pzena analysis
¹Cheapest quintile price to book of the ~1,000 largest US stock universe (equal-weighted data). ²Cap-weighted universe data.
We define a cycle as when the relative performance of value vs. the market from the last peak or trough is at least +/-1500 basis points and has persisted for a minimum of 12 months. Returns do not represent any specific Pzena product or service. Past performance is not indicative of future returns.

Moreover, as Figure 2 illustrates, there appears to be a connection between the length and magnitude of pro-value cycles and their preceding anti-value cycles. The current value rally follows the second worst anti-value cycle of the past 50 years, in both duration and magnitude. Whereas the last pro-value cycle – subdued by comparison – followed a fairly mild anti-value cycle, we believe the length and depth of the most recent anti-value cycle bode well for a long and enduring pro-value cycle. We also observe that the outperformance in prior pro-value periods was earned over the course of the entire cycle, not just in its early phases. Recall that on average value outperforms the market by about 400 basis points annualized for the five years following a recession.

Figure 2: History of Value1 Outperformance Vs. The Market²

Source: Sanford C. Bernstein & Co., Pzena analysis
Blue solid line within chart represents a relative index displayed using a logarithmic scale.
¹Cheapest quintile price to book of the ~1,000 largest US stock universe (equal-weighted data). ²Cap-weighted universe data.
We define a cycle as when the relative performance of value vs. the market from the last peak or trough is at least +/-1500 basis points and has persisted for a minimum of 12 months. Returns do not represent any specific Pzena product or service. Past performance is not indicative of future returns. Data in US dollars through March 31, 2021.

RECOVERY MATH

There is no doubt that businesses were hit hard by the economic collapse spurred by the pandemic. However, management teams did not sit still. Rather they cut costs and restructured operations to an extent that may not have been possible absent such an acute crisis. As a result, earnings recovery is likely to be swift and powerful. Cyclical companies, whose earnings were most impacted by the lockdown, should see the strongest earnings growth, as revenues recover, and operating margins expand as expenses are held in check. Additionally, unlike other cyclical downturns, many businesses are coming out of this downturn with depleted inventories. A combination of inventory re-stocking and investments to reconfigure supply chains – to make them more resilient to an economic shock and trade politics – should provide an even greater surge in top and bottom lines than in a typical cyclical recovery.

Looking at the cheapest quintile on price to normalized earnings provides a good example of the recovery these deeply undervalued businesses might enjoy over the next couple of years (Figure 3). Earnings of these companies were cut by a third in 2020. Yet Wall Street analysts project a classic V-shaped rebound in earnings this year – up nearly 70% to surpass 2019 levels – and a 24% compound annual growth rate in earnings out to 2023. We are seeing a similar trajectory of earnings collapse and recovery in the global universe.

Figure 3: Value Stocks’ Rapid Earnings Recovery

Source: FactSet, Pzena analysis
Net Income of the cheapest 20% of stocks within the ~1,000 largest US stock universe (using Pzena’s price-to-normal estimates), measured on an equally weighted basis. As of March 31, 2021.
2021 – 2023 earnings based on consensus estimates per FactSet as of March 31, 2021. For illustrative purposes only. All data in US dollars. Does not represent any specific Pzena product or service.

WHEN VALUE BECOMES MOMENTUM

During last March’s sell-off, investors found it difficult to look through to the end of the pandemic. That is understandable, as it is extremely difficult to figure out when economic activity will return, and impossible to determine when investor sentiment will improve. For disciplined value investors, it is the darkest periods – when sentiment is at its lowest – where the hard work is most rewarded as earnings and sentiment typically recover, often in a sudden, unexpected, and extreme manner.

One of the interesting features of a value cycle is how the momentum characteristics of value stocks change over time, attracting a wider circle of investors. Figure 4 shows the 22-year history of sentiment for value stocks, as represented by the percentage of value stocks among the top third in positive price momentum. Value cycles start with a sudden and sharp move from extremely out-of-favor to in-favor, as we saw in the fourth quarter of 2020. After an initially sharp increase in the percentage of cheap stocks within the high momentum cohort, the percentage tends to remain broadly above average throughout the value cycle. The jagged nature of the line reflects rotation and the increasing participation of momentum-oriented and more mainstream investor types. The line moves down as formerly inexpensive stocks cycle out of the cheapest quintile and are replaced with newly out of favor stocks not yet experiencing a re-rating. Once these stocks catch the attention of the broader market, and prices catch up to fundamentals, they move into the positive momentum category, and the blue line heads back up. It is the continuation of this dynamic in markets, until valuation spreads return to more normal levels, that explain the long durations of value cycles that we have observed historically.

Figure 4: Percent of Cheap Stocks Among High Momentum Stocks

Source: FactSet, FTSE Russell, Sanford C. Bernstein & Co., Pzena analysis Blue line represents low price-to-book (the cheapest quintile) stocks that also qualify as high momentum stocks within the Russell 1000 Index. We define high momentum for this analysis as the stocks within the best tertile of stock price performance during the previous 12 months. This analysis was done on a quarterly basis from 12/31/1998 – 3/31/2021. The pro-value cycles represented by the shaded areas was calculated using the same methodology discussed in the footnotes of Figures 1 and 2. Past performance is not indicative of future returns.

This represents the value approach in a nutshell: having the fundamental research and discipline to buy good businesses when their path of profitability is at its most uncertain typically pays off when earnings recover, and sentiment improves.

CONCLUSION

Returning to our original questions, we believe a number of factors point to the likely start of a long and enduring value cycle, including:

• the starting point for value is attractive, particularly relative to the overall market valuation
• the brevity of the current value rally to date compared to past value cycles,
• strong projected earnings growth for value stocks, and
• significant opportunity for re-rating as sentiment continues to improve.

This value rally began as in past cycles; sentiment improved dramatically over a relatively short period of time. The relatively modest outperformance of value compared to past value cycles, and the extreme depth of the previous anti-value cycle, all portend a strong recovery. Although these recoveries can be bumpy as uncertainties are resolved, the evidence indicates we are in the early stages of what may be a powerful period of value outperformance.

DISCLOSURES

These materials are intended solely for informational purposes. The views expressed reflect the current views of Pzena Investment Management (“PIM”) as of the date hereof and are subject to change. PIM is a registered investment adviser registered with the United States Securities and Exchange Commission. PIM does not undertake to advise you of any changes in the views expressed herein. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance is not indicative of future results. All investments involve risk, including risk of total loss.

This document does not constitute a current or past recommendation, an offer, or solicitation of an offer to purchase any securities or provide investment advisory services and should not be construed as such. The information contained herein is general in nature and does not constitute legal, tax, or investment advice. PIM does not make any warranty, express or implied, as to the information’s accuracy or completeness. Prospective investors are encouraged to consult their own professional advisers as to the implications of making an investment in any securities or investment advisory services.

London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). ©LSE Group 2020. FTSE Russell is a trading name of certain of the LSE Group companies. Russell® is a trade mark of the relevant LSE Group companies and is used by any other LSE Group company under license. All rights in the FTSE Russell indexes or data vest in the relevant LSE Group company which owns the index or the data. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company’s express written consent. The LSE Group does not promote, sponsor or endorse the content of this communication.

For U.K. Investors Only:

This financial promotion is issued by Pzena Investment Management, Ltd. (“PIM UK”). PIM UK is a limited company registered in England and Wales with registered number 09380422, and its registered office is at 34-37 Liverpool Street, London EC2M 7PP, United Kingdom. PIM UK is an appointed representative of Mirabella Advisers LLP, which is authorised and regulated by the Financial Conduct Authority. The Pzena documents are only made available to professional clients and eligible counterparties as defined by the FCA. Past performance is not indicative of future results. The value of your investment may go down as well as up, and you may not receive upon redemption the full amount of your original investment. The views and statements contained herein are those of Pzena Investment Management and are based on internal research.

For Australia and New Zealand Investors Only:

This document has been prepared and issued by Pzena Investment Management, LLC (ARBN 108 743 415), a limited liability company (“Pzena”). Pzena is regulated by the Securities and Exchange Commission (SEC) under U.S. laws, which differ from Australian laws. Pzena is exempt from the requirement to hold an Australian financial services license in Australia in accordance with ASIC Corporations (Repeal and Transitional) Instrument 2016/396. Pzena offers financial services in Australia to ‘wholesale clients’ only pursuant to that exemption. This document is not intended to be distributed or passed on, directly or indirectly, to any other class of persons in Australia.

In New Zealand, any offer is limited to ‘wholesale investors’ within the meaning of clause 3(2) of Schedule 1 of the Financial Markets Conduct Act 2013 (‘FMCA’). This document is not to be treated as an offer, and is not capable of acceptance by, any person in New Zealand who is not a Wholesale Investor.

For Jersey Investors Only:

Consent under the Control of Borrowing (Jersey) Order 1958 (the “COBO” Order) has not been obtained for the circulation of this document. Accordingly, the offer that is the subject of this document may only be made in Jersey where the offer is valid in the United Kingdom or Guernsey and is circulated in Jersey only to persons similar to those to whom, and in a manner similar to that in which, it is for the time being circulated in the United Kingdom, or Guernsey, as the case may be. The directors may, but are not obliged to, apply for such consent in the future. The services and/or products discussed herein are only suitable for sophisticated investors who understand the risks involved. Neither Pzena Investment Management, Ltd. nor Pzena Investment Management, LLC nor the activities of any functionary with regard to either Pzena Investment Management, Ltd. or Pzena Investment Management, LLC are subject to the provisions of the Financial Services (Jersey) Law 1998.

For South African Investors Only:

Pzena Investment Management, LLC is an authorised financial services provider licensed by the South African Financial Sector Conduct Authority (licence nr: 49029).

© Pzena Investment Management, LLC, 2021.  All rights reserved.