Ideas Farm: Value’s death knell?

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  • Rising interest rates is meant to be good for value investors…
  • …but the evidence is scant.
  • Could higher rates kill off the remaining support for traditional value investing?
  • There is another way.
  • Loads of new idea-generating data.

The wait may be finally over. After a decade of anticipation that began as quantitative easing cranked up following the credit crunch, sustained inflation may finally be here. 

Sure, the post lockdown jump we’ve seen in prices may yet prove another false dawn. But even if that’s the case, it at least looks likely we’ll see interest rates continue to rise through 2022. 

Fans of the much-maligned value investment style have long complained that low interest rates prevent the natural mechanics of capitalism that drive outperformance from the so-called ‘value factor’. We’re told that loose monetary conditions have led to a proliferation of ‘zombie companies’. This has stopped supply being drained from cyclical industries, which in turn has prevented healthier companies rebuilding profitability. Quantitative easing and ultra-low interest rates have bypassed the creative destruction of capitalism.

And that’s not the only bug-bear value investors have with low interest rates. The risk-free return from putting money in a bank account (or government bonds) has a strong bearing on the price investors are prepared to pay for earnings in the distant future. The lower rates are, the higher the price tag future earnings command. A popular argument is that this means low interest rates favour growth stocks that promise lower profits now, but larger profits in the future. Value stocks, which offer more now and less in the future, therefore underperforms. 

The logic of these narratives feels intuitively compelling. As long as interest rates remain low, it goes relatively unchallenged. But with interest rates rising, a test approaches. What will value stocks do?

A paper from quant investor AQR from early 2020 had some rather worrying news for traditional value investors. It found that despite some eye-catching recent trends, over the long term, the significance of any relationship between value investing and interest rates was at best small and not robust across the many different tests it conducted.

In reality, tightening monetary conditions will probably be a bit of a mixed bag for traditional value sectors. Those companies that have lowly-rated shares due to overstretched balance sheets, for example, are likely to suffer due to a higher cost of debt and a tougher lending environment. And companies that have cheap shares due to their weak market positions and lack of pricing power may suffer due to an inability to pass on cost inflation.

Other traditional value sectors could do well, though. Companies that are reliant on hard assets are often considered a good inflation hedge. That means the property and commodity companies that make up a good chunk of the value space could do well. So too could the financial companies that are also heavily represented in most value indices. That’s especially true of banks, which tend to make a bigger spread between the interest rates they lend at and borrow at when rates are higher. 

Given all this nuance, it is probably folly to hope for easy answers to such a complex question as whether tighter monetary policy will cause a value renaissance. However, the debate over recent years may have left many with the expectation that value needs to outperform if interest rates rise. If this does not happen, remaining acolytes of a traditional value approach may finally lose faith.

However, the fixes needed to make value investing work again may simply lie in moving away from traditional valuation measures. Certain accounting standards related to intangible investment have made these old-school metrics highly ineffective. Indeed, a US value ETF firm Distillate Capital, which uses non-traditional metrics, has found that based on its preferred free-cash-flow based valuation measures, the Russell 1000 Growth index was actually cheaper than the Value version of the index from 2009 up until early 2020. The fact this trend has recently reversed may actually hold bigger hopes for traditional value investors than higher interest rates.  

Some links:

Thomas Maloney, Tobias J. Moskowitz, AQR Capital, “Value and Interest Rates: Are Rates to Blame for Value’s Torments?“, Jun 2020

Finding Hidden Value, 25 Feb 2021