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The value stock reflation may be at hand: James Saft

[January 12, 2017] By James Saft

(Reuters) - If the Trump reflation actually comes few will be happier than value investors.

Value stocks in the S&P 500 have outperformed the broad index since the election by more than two percentage points, extending their strong performance since the beginning of 2016.

That’s a huge reversal of their performance since the financial crisis, since when value stocks underperformed, suffering in comparison to more glamorous areas like technology.

Value stocks, typically those that trade at lower multiples of earnings or book value, generally require more patience than growth stocks, in part because they are, by definition, unloved, and depend on a fundamental change in market opinion.

In the case of individual stocks, that hangs on improving performance at a given company, but for the investing approach as a whole to outperform requires a cyclical shift.

The expectation that U.S. growth will get a reflationary bump from President-elect Donald Trump’s spending plans is just that: the kind of event which may fundamentally change investor preferences.

Bond yields have headed higher as investors try to front-run both wage and inflationary pressure from stronger growth and a newly hawkish Federal Reserve.

“The jump in global bond yields represents a reflationary reawakening just a year after deflation and recession fears were dominant. Is this another false dawn? We don’t think so,” Philipp Hildebrand and Jean Boivin of BlackRock write in a note to clients.

“This is an important psychological shift for investors previously obsessing over downside risks to growth and inflation, typified then by the talk of 'secular stagnation' and 'liquidity traps'.”

The key concept is that equities are the longest duration assets. Investors don’t get their capital back on a schedule but share, theoretically, in all future income generated by the company.

That means that as investors demand a bigger premium for holding longer duration assets like 10-year bonds, something they now want because they at last fear, even a little, inflation, other longer duration assets like stocks similarly benefit.

Combine a long-duration asset with the low valuation of value stocks, analysts at investment bank Jefferies argue, and you should get a re-pricing upwards as long yields rise more than short-term ones.

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WORLD-WIDE BET?

While the impetus for the repricing is coming from the U.S. election, the re-pricing and inflationary impulse are arguably broader based and predate Trump.

“The big turning point must be the rise in inflation. It is interesting to note that just as the U.S. presidential election took place, both Chinese and U.S. corporate inflation indicators have turned. Once again this will favor companies with high operational and financial leverage,” Jefferies analysts wrote in a note to clients.

“The bottom line is that higher long rates ought to favor low price-to-book, low price-to-equity and improving asset turnover and is likely to prove a drag on expensively valued stocks with stable asset turnover. 2017 should turn out to be a good year for active value investors.”

The upshot is that what had been cheap - value stocks and the long-beaten down bank sector - gets re-rated upward almost mechanically as the yield curve steepens. There are many more of these types of shares in Japan and Europe, which have struggled particularly in generating inflation. A little inflationary impulse from abroad would go a long way toward expanding P/E ratios.

Lots of companies with high fixed costs suffered during the tepid but long-running recovery. Overall sales growth has been weak and, with inflation quite low, companies in many value sectors have had very little ability to raise prices. A bit of growth and companies with those high fixed costs can generate strong profit growth, justifying an expansion in the amount investors will pay for a given dollar in earnings.

The risk, of course, is that financial markets move much faster than economic recoveries. They also operate on animal spirits. Prices for many value-type stocks, notably banks, have already caught up a great deal. If, for example, Trump and Congress don’t come through with the expected stimulus, the earnings increase investors are now expecting won’t come through. A sharp reversal away from value is likely.

Betting on U.S. economic policy is a high-risk sport these days, but value stocks may well offer suitably high rewards.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)

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