Tide May Be Turning For Value
In recent years the returns have not been pretty for value stocks, the ugly ducklings of the investment world. The S&P 500 Value Index delivered a total return of 3% in the past five calendar years, while its sister Growth Index returned 29%. Relative to the market, the cheap have gotten cheaper.
Over the last 40 years, large-cap value stocks have tended to outperform growth stocks during years when large stocks as an asset class lost money. But that trend failed to materialize during the financial crisis of late 2008 and 2009, when once-mighty companies disappeared and many others teetered on the brink of extinction. The crisis in confidence caused a flight toward quality, including growth companies capable of fortifying their balance sheets through strong cash flows.
Even as the U.S. economy slowly regained its footing, value stocks continued to lag. This behavior holds closer to form, as value stocks tend to underperform during periods of slowing earnings growth. As operating momentum becomes scarce, investors often push up the prices of the shrinking number of companies still delivering strong growth.
Although value investing falls out of favor for stretches, it can deliver big returns when it works. In rolling 12-month periods since 1994, the top one-fifth of the S&P 1500 Index as measured by QuadrixÂ® Value scores outperformed the average stock in the index by an average of 2.6%. No other Quadrix category works so well.
Academic studies have found the market tends to overreact to bad news while underreacting to good news. Stocks battered by a wave of bad news have more room to appreciate than stocks that already have a lot of optimism built into their prices. Extreme scenarios don't last forever, and a reversion to the mean tends to adjust stock prices after market sentiment swings too far in one direction.
Today, value seems due for a rebound — though not because of a promising outlook for near-term earnings growth. The broad S&P 500 Index is projected to report 2.7% higher earnings per share in the first quarter of 2013, accelerating to 7.1% in the second quarter and 10.3% in the third quarter.
Nevertheless, S&P 500 Value has begun to gain traction, returning 17.7% last year versus 14.6% for S&P 500 Growth. Value has outperformed growth in each of the last four rolling 12-month periods. And so far this year, the value index is up 7%, more than two percentage points above the growth index's gain.
In the past 199 rolling 12-month periods dating back to July 1996, growth holds a slight edge, outperforming value 56% of the time. But when value gets going, it can post prolonged win streaks, such as 29 straight periods from December 2000 through April 2003, 45 straight periods from November 2003 to June 2007, and seven straight periods from February 2010 to August 2010.
In the wake of a five-year run-up, growth stocks trade at a bigger premium to value stocks than usual. The S&P 500 Growth Index's price/sales ratio is 90% higher than that of the S&P 500 Value Index, well above its 10-year average premium of 72%. Growth looks even pricier relative to book value, trading at a 126% premium to the value index, versus the 10-year average of 82%. As investors become more comfortable taking on risk, they will likely start dusting off stocks in the discount bin.
Moreover, U.S. corporations are hoarding cash. Cash holdings of nonfinancial stocks in the S&P 500 Index reached $1.23 trillion at the end of September, up more than 50% from five years ago. Should growth remain scarce, companies will become more tempted to buy higher profits via the acquisition of undervalued rivals.
Of course, most of the large-cap stocks in the table below aren't takeover targets. But they earn high Overall scores and their shares look unduly cheap, positioning them to benefit once value comes back into favor. Three of the stocks are reviewed below.
Since the financial crisis, the exposure of Aflac's ($53; AFL) investment portfolio to European bonds has weighed on the shares. Now investor concerns seem to center on the Japanese yen eroding against the U.S. dollar. Japan accounts for about 80% of Aflac's operating earnings, and a stronger yen modestly helped Aflac's operating results in the first nine months of 2012.
But in the December quarter, the yen depreciated more than Aflac projected, which could make it tough for the insurer to meet its earnings-per-share target of $1.46 to $1.51. The consensus calls for earnings of $1.48 per share, implying 2% growth. The yen has continued to weaken versus the dollar in January, falling to levels last seen in the June 2010 quarter. However, a lot of pessimism appears embedded in the shares, trading at eight times trailing earnings, 37% below their five-year average. The company will announce December-quarter results Feb. 5. Aflac is a Focus List Buy and a Long-Term Buy.
The 35% plunge in Apple ($458; AAPL) shares from its September peak and 11% decline since the December-quarter report leaves investors wondering what went wrong. Sales still rose 18% for the quarter, but that marked the slowest growth since the June 2003 quarter. The quarter contained one fewer week than last year, and shortages of the iPad mini and new iMac also weighed on results, probably pushing some sales into the March quarter.
Apple finds itself battling the massive expectations that have come from delivering nearly a decade of phenomenal growth. After missing the consensus sales estimate for a third straight quarter, Apple tried to reset analyst expectations, suggesting that going forward they base theirÂ projections on Apple's guided range rather than its history of outperformance. The market didn't take kindly to these comments, but perhaps it's the first step in realigning expectations. Apple remains a Focus List Buy and a Long-Term Buy.
With a maximum Overall score of 100, CF Industries ($229; CF) ranks in the top 15% of our research universe for both Value and Momentum. CF is expected to post a third straight quarterly revenue decline when it announces December-quarter results, and the consensus projects a profit decline of nearly 4% for the quarter and 8% for 2013. But the consensus profit target for the full year has edged up over the last month, and there are reasons to believe CF can top expectations.
U.S. crop prices have proved resilient, as farmers in parts of South America report unusually dry conditions. High crop prices should support fertilizer demand as farmers prepare for the 2013 planting season. The stock surged 40% last year and has gotten off to a strong start in 2013, up 13%. Yet CF shares still look attractively valued at eight times trailing earnings, a 27% discount to their three-year average. CF Industries is a Focus List Buy and a Long-Term Buy.