It’s Time to Give Value Stocks Another Look

Value stocks have experienced significant underperformance in recent years, but the tide finally may be about to turn. If you’re considering options for year-end portfolio reallocation, value stocks may be one of the most compelling ideas for 2016.

best index funds ETFsInvestors can be forgiven if value stocks seem like an unexciting prospect right now, since the style has been hammered across all segments of the market so far this year.

Year-to-date through Nov. 13, the Russell 1000 Value Index had posted a loss of 4.3%, well behind the 4.7% gain for the Russell 1000 Growth index. Value has experienced similar, albeit smaller, underperformance within both the mid- and small-cap universes as well.

The primary reason for the shortfall in value is investors’ preference for stocks that can deliver rising earnings even without the tailwind of positive economic conditions.

While this has been a downer for those invested in value stocks, there are also plenty of reasons to hope for a renewed opportunity in the asset class.

One important cause for optimism is that growth stocks have moved out to a significant longer-term performance advantage over value. The Russell 1000 Growth Index had a 10-year average annual return of 8.48% through Friday, versus 6.30% for the value index. This represents a contrast to the historical performance trend: According to Fidelity Investments, value had outperformed growth in 86% of the rolling 10-year periods from 1980-2010.

The upshot: Value stocks are in line for a mean reversion, raising investors’ odds of success in the asset class.

Momentum Stocks Creating a Large Valuation Gap

The valuation disparity between the two styles helps make the case that such a reversion could occur sooner rather than later.

The relative valuations of growth and value can be seen in the wide gap in the P/E ratios of two large-cap ETFs. The iShares Russell 1000 Growth ETF (IWF) is currently 23.1 times earnings and 5.7 times book value, while iShares Russell 1000 Value ETF (IWD) is trading at 15.9x earnings and 1.8x book value.

Growth will always trade with a premium, of course, but the current gap is very high by historical measures, indicating that value stocks are trading at a potentially attractive discount at their current levels. This could act as cushion if the broader market experiences a selloff in the months ahead — a key feature for those looking to reduce risk while maintaining equity exposure.

Another aspect of the valuation argument is that growth funds have a heavy tilt to the type of momentum-driven technology stocks that have delivered big gains thus far in 2015, such as Amazon (AMZN), Facebook (FB), and Alphabet (GOOG, GOOGL).

These three stocks make up about 8.5% of the Russell 1000 Growth Index. That performance certainly been a plus this year, as the three stocks have posted year-to-date gains of 107% 33%, and 41%, respectively. Unfortunately, it also indicates that there is a heavy element of past performance that is already built into the growth universe at this stage.

Rising Rates May Be a Plus

Another plus for value stocks is their tendency to outperform when the U.S. Federal Reserve is raising interest rates. While the Fed is unlikely to embark on a prolonged series of rate hikes, all signs point to the likelihood of an increase as soon as December.

Such a move would be a tailwind for value stocks in general, and also for the large swath of the value universe made up by the financial sector. The Russell 1000 Value has a whopping 30% of its assets in financials, compared with just 5.5% for the Russell 1000 Growth.

If the historical pattern holds and financials indeed outperform once the Fed starts boosting rates, value stocks have a large built-in advantage over growth.

Commodities: Short-term Pain, Longer-term Gain?

One potential issue with value stocks is their higher exposure to commodity prices. The Russell 1000 Value has a weighting of approximately 16% in energy and materials, compared with an allocation of 4.3% in the growth index.

Investors therefore need to be aware that a further downturn in commodities will likely translate to continued underperformance for the value style. On the flip side, with both commodities and materials-related stocks having fallen so far this year, a higher energy weighting could actually prove to be a positive attribute in the year ahead.

If the commodities sectors catch the markets by surprise and recover in 2016, value funds are almost certain to outperform.

Verdict on Value Stocks vs. Growth Stocks

The growth vs. value debate may seem somewhat old-fashioned at a time in which broader-based index ETFs have diverted attention away from the traditional “style boxes” popularized by Morningstar.

However, the positive catalysts for value stocks are beginning to line up as 2015 winds to a close. Investors should consider value funds over core or growth-oriented options when it comes time for year-end reallocations.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

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