Why Have Value Stocks Been Doing So Well? Hint: It Isn’t Inflation.

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A supermarket in New York City: Value stocks outperform regardless of inflation.

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Angela Weiss/AFP/Getty Images

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Worsening inflation is most likely not the reason why value has beaten growth by so much this year.

That’s the implication of a new study that analyzed how inflation impacts the relative returns of value and growth stocks. It found that, on average, value’s lead over growth has been remarkably consistent over the decades regardless of whether inflation was low, moderate, or high. That runs directly to counter the prevailing narrative on Wall Street that value stocks do better when inflation is running hottest.

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Challenging this narrative is important not just as a matter of historical and theoretical accuracy. It is also crucial for predicting value’s likely fate in the event inflation recedes over the next 12-24 months, as many—including members of the Federal Reserve’s interest-rate setting committee—believe.

The new study, “Investing in Deflation, Inflation, and Stagflation Regimes,” began circulating in academic circles earlier this month. It was conducted by three researchers at Robeco Institutional Asset Management in the Netherlands: Guido Baltussen, Laurens Swinkels, and Pim van Vliet. Baltuseen and Swinkels are also finance professors at Erasmus University Rotterdam.

The researchers analyzed inflation’s impact on value and growth stocks in the US going back to 1866, which is 60 years before the beginning date of any other study on this subject. To do that, they were able to take advantage of a monumental database project at Robeco to gather data on individual stocks back to January 1866. The researchers divided all calendar years since then into four groups depending on that year’s rate of inflation, and in each group measured the performance difference between the average value and growth stock.

The accompanying chart reports what the researchers found. Notice that value’s alpha—that is, its outperformance over growth—was remarkably similar across all four inflation groups. The researchers report that the differences between the groups aren’t significant at the 95% level that statisticians often use when determining if a pattern is genuine.

Why the Prevailing Narrative Is Mistaken

The researchers’ finding is surprising since the prevailing narrative is at least superficially quite plausible. Growth stocks—those trading at higher ratios of price to various measures of fundamental value, such as earnings or book value—are heavily dependent for their valuations on the more distant future. They therefore are especially vulnerable to higher inflation, since that means the present value of their future earnings and cash flows will be correspondingly less.

In contrast, value stocks—those trading for lower ratios of price to fundamental value—are more dependent for their valuations on the present. As a result, the prevailing narrative goes, they are relatively immune to changes in inflation. So they benefit in relative terms when inflation is high, and their alpha suffers when inflation is low—as, for example, it’s been over the past decade.

The flaw in this narrative, according to Richard Warr, a finance professor at North Carolina State University, is that it overlooks the impact that inflation has on earnings growth rates. Though higher inflation does lower the present value of future years’ earnings and cash flow, future earnings and cash flows will most likely be higher than otherwise when inflation heats up. These two factors should balance out, he said in an interview, which is why value’s historical advantage over growth shouldn’t be dependent on inflation.

That’s the theory, and this new Robeco study provides empirical confirmation. To be sure, Warr added, this doesn’t mean investors don’t sometimes make the mistake of thinking high inflation is good for value stocks and low inflation is bad. But it is still a mistake—whats economist variously describe as “money illusion” or “inflation illusion.”

The investment implication, Warr continued, is that “if inflation recedes and value stocks get hammered, we should use it as a buying opportunity.”

Betting on Value’s Alpha

If we shouldn’t look to worsening inflation to explain why value has beaten growth, what is the likely cause? No doubt there are many causes, according to researchers I interviewed for this column. One is that the weight of long-term history is on value’s side. A separate Robeco study, for example, found that value stocks have been beating growth stocks at least since 1866—more than 150 years ago. That’s a long-enough period to make it a good bet to persist into the future.

Another probable cause of value’s strong relative performance in recent months is that the average value stock had become unprecedentedly cheap relative to the average growth stock. Despite the value sector’s outperformance so far this year, it’s still trading at historically low valuations relative to the growth sector.

Note carefully that the Robeco results reported here reflect value’s alpha over growth. To bet on that alpha going forward, you would need to simultaneously invest in a diversified basket of value stocks and sell short an equal dollar amount in a basket of growth stocks. That is easier said than done. A mutual fund or exchange-traded fund is the obvious solution, but there are hardly any such funds or ETFs to choose from which offer such a strategy.

The fund that perhaps comes closest to providing a bet on value’s alpha is the Vanguard Market Neutral fund (ticker: VMNFX). It focuses on several different investment factors, or styles, in deciding which stocks to buy and which to short, but “value” is one on which they rely heavily. The fund has a high expense ratio, however, especially for Vanguard: 1.31%, or $131 per $10,000 invested.

This year, Vanguard Market Neutral has produced a 7% total return, compared with a 19.2% loss for the S&P 500 index,
Impressive as that is, bear in mind that the fund’s expected return will be low when value’s alpha is lower than it was this year. For the 10 years through the end of 2021, for example, it produced a total annualized return of just 1.3%.

A somewhat more cumbersome way of betting on value’s alpha, but one with a much lower expense ratio, is to buy a value-stock ETF and sell short a growth-stock ETF. Shorting involves borrowing shares of an asset, hoping to return them later at a lower price. When the shorting is done in conjunction with going long, it can actually reduce risk, though done by itself it can be very risky.

Two good ETFs for such a long-short bet on value’s alpha are the Vanguard Value ETF (VTV) and the Vanguard Growth ETF (VUG). Each has an expense ratio of 0.04%, or $4 per $10,000 invested. The Vanguard Value ETF has done nearly 20 percentage points better than the Value Growth ETF since the beginning of the year.

Would investing in value stocks alone—say, by substituting a value-focused fund for broad-market one as a core holding—provide a good hedge against inflation? Only partially, Prof. Baltussen said in an interview. He said that he and his co-authors found that, during periods of high inflation, while a value-stock portfolio lost less than the overall market, it still lost. For example, the Vanguard Value ETF has lost 9.4% so far this year, even if it has greatly outperformed the Vanguard Growth ETF’s 29.0% loss and the S&P 500’s 19.2% loss.

Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]

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Credit: www.marketwatch.com /

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