U.S. value stocks (represented by the Russell 1000 Value Index) significantly outperformed U.S. growth stocks (represented by the Russell 1000 Growth Index) from the peak of the tech bubble in March 2000 through the market top in October 2007 that preceded the global financial crisis. This edge has since eroded in what has largely been a decade-plus of outperformance by growth stocks. The combination of historically-low interest rates, muted inflation, moderate gross domestic product growth, and the explosive performance of technology companies has propelled growth companies, culminating in their rapid ascent over the past two years.

Meanwhile, U.S. value has performed so poorly relative to U.S. growth over the past decade that only about 5% of previous 10-year periods have been worse (defined as a two-standard-deviation event), according to our analysis. With only a few short-term wins since 2008 and staggering overall underperformance, many investors are losing faith in U.S. value.

Yet, even with its past decade of significant underperformance, the U.S. value asset class has still outperformed its growth counterpart by an average of about 0.98% over rolling 10-year periods from December 1978 through March 2019 (Exhibit 1). This is why we maintain exposure to value stocks as part of our Fund portfolio construction process.

Furthermore, we believe the current performance gap between U.S. growth and value represents what may be the most attractive investment environment for value stocks that we have seen in nearly 20 years. In our opinion, it is a question of when—not if—a value orientation will pay off.

Historically, value typically mean reverts (or outperforms) relative to growth after periods of prolonged underperformance. Accordingly, our U.S. equity funds favour value managers—overweighting positions in value stocks in recognition of attractive earnings, cash flows, dividends and assets.

Domestically, the story is more nuanced. Value stocks are struggling in Canada just as they are in the rest of the world. The distinction is that Canadian value stocks have higher representations in more volatile, economically-sensitive areas such as industrial commodities (7% weight in S&P/TSX Composite Index), energy excluding pipelines (13%), consumer durables (2%) and financials (33%). As such, value stocks comprise over half of the S&P/TSX Composite Index but are mostly concentrated in just four industries/sectors. While these companies are currently trading at inexpensive valuations, uncertainties about global growth are keeping valuations from rising. Accordingly, traditional value in Canada is perceived as riskier and, in many cases, of lower quality. Given the apparent late stage of the current economic cycle, it is not unusual to see these sectors struggle relative to growth-oriented sectors.

Why do Mean Reversions Happen—and What do They Look Like?

Benjamin Graham—widely considered the father of value investing—said that “in the short run, the market is a voting machine; but in the long run, it is a weighting machine.”

He argued that short-term popularity should not be confused with long-term value; that, eventually, a company’s intrinsic value will be reflected in the price of its shares. Mean reversion is the vehicle by which that value recognition occurs.

Data from famed academic and author Ken French1 show that prolonged periods (defined as rolling five-year time horizons) in which U.S. value underperforms growth have historically been followed by significant outperformance by value over the following three years. Although recent returns may imply otherwise, U.S. value has rebounded and outperformed in more than 70% of these scenarios since 1927.

It’s not just the frequency, but also the magnitude of the gains generated by these formerly unloved stocks. In about one-third of observations, U.S. value stocks outperformed by an average of 7% to 15% annually. In nearly 15% of instances, U.S. value’s outperformance exceeded an annualized 15%.

While the returns in Exhibit 2 appear quite attractive, they also came after periods of underperformance. The current environment is one of the longest and most significant periods of underperformance for U.S. value on record.

Value’s Uncomfortable Truth

Most investors believe buying low and selling high is a strategy that will generate long-term gains. But purchasing stocks when they’re down tends to feel unnatural and uncomfortable. Holding cheap value stocks while growth-oriented technology stocks continue to soar also frustrates many investors. When it comes to value investing, however, patience really can be a virtue.

1 Data Library, courtesy of Professor Kenneth R. French. Tuck School of Business, Dartmouth College.

Our portfolios are diversified across a number of factors, including value, momentum, stability, size and quality. Yet we’ve had a value orientation for several years. Admittedly, the value tilt (which is more pronounced in our U.S. equity funds than in our Canadian equity funds) has detracted over the past decade. But history shows that investing in value when it’s hardest to embrace the asset class has generally provided the biggest subsequent payoffs.

So When will it Happen?

Everyone wants to know when value will return to favor and which catalyst will cause the turn. 

The short answer is that value trades are notoriously hard to time, and investors risk missing out on potentially impressive gains by being late to the trade.

That said, we think a number of potential catalysts could turn sentiment in favour of value, including:

• Rising interest rates (extremely low now)
• Higher commodity prices
• Increased inflation
• Faster economic growth
• Sector differentials in the U.S. (energy over health care has led to recent value outperformance; financials have also started beating technology)
• Technology stocks failing to meet investors’ lofty expectations

This is not an all-encompassing list of potential catalysts. It’s also possible the catalyst that ultimately causes the turn toward value has yet to even be identified.

Being early to the trade eliminates the need to guess the correct catalyst; investors must simply be patient enough to wait for the market to turn. We acknowledge this may be a challenging mental exercise, given U.S. value’s underperformance in the past 10 years. 

A Behavioural Bias

SEI is a pioneer in behavioural finance, and this field of study continues to influence our thinking today.

Consider recency bias. This describes an investor’s ability to remember items that appear at the end of a long list of complex data, rather than those that appear earlier.

Evaluating conditions in the financial markets often involves reviewing long lists of complex information. Most investors do not have systems in place to automatically capture important data points going back many years or decades. Even those who do have such systems may not place sufficient weight on older data points.

There are many examples of recency bias throughout the history of financial markets. The last prominent example took place in early 2000. After four years of a raging bull market in technology, media and telecommunications stocks lifted the market to new highs, investors—professional and amateur—believed that it was “different this time;” despite having experienced past boom and bust cycles, many expected the soaring tech-bubble stocks to keep rising unabated. As we know now, this was not the case, as the tech bubble deflated in a tragic spectacle.

Looking back even further, the “nifty fifty” saw a few dozen companies drive U.S. market gains in the 1960s and early 1970s. Yet these same companies lagged the market in the 1980s.

Every market environment is different, but parallels with the current U.S. market are easy to spot. The FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) look quite expensive. These firms, along with a handful of other high-flying tech stocks, have led the bulk of gains in the S&P 500 Index in recent years. Meanwhile, unloved value stocks have once again been left behind. It’s worth noting that value stocks went on quite a run after the tech bubble burst. It’s easy to imagine a similar environment if market leadership shifts.

Investors can fight recency bias by remembering that long-term relationships usually hold up for good reason. For example, the relationship between the cash flow that a firm can deliver and the stock price it supports should not vary by large degrees for long periods of time. Eventually, history shows it will revert toward the mean. Investors need to ask whether it’s truly different this time. We don’t believe that is the case.

A Look Into our Portfolios

In the U.S., FAANG stocks are concentrated in the information technology and communications sectors, so it’s not a surprise that we are underweight those sectors in most portfolios. But our funds are also underweight some sectors that have been dubbed value by index provider Russell.

For example, utilities are most often classified as value by index providers. Yet we don’t find them particularly attractive on a valuation basis. They also lack the growth characteristics of FAANG stocks.

With regard to U.S. value, our most prominent overweight tends to be in the financials sector. These companies often trade with attractive price-to-book ratios, and currently have low price-to-earnings ratios along with rising dividends. Bank earnings are benefiting from recent increases in short-term interest rates. Although it appears the U.S. Federal Reserve may be finished hiking rates for the time being, the steady rate increases from late 2016 through late 2018 have resulted in the highest short-term rates in over a decade.

Our portfolio construction is not predicated on market timing. We believe that trying to perfectly time trades to capture market inflection points is a futile exercise. Instead, we assess where it makes the most sense to invest the next incremental dollar, and make our decisions accordingly.

In an environment where growth is scarce (Exhibit 3), investors will often pay a premium for the asset class. We don’t believe the expected incremental growth of the Russell 1000 Growth Index over the Russell 1000 Value Index is worth a significant premium. While most of our U.S. funds are not explicitly dedicated to value strategies, we have a preference for value stocks as they offer distinctly attractive valuations.

In Canada, we are taking a more measured approach to traditional value, sticking to our strategic 33% allocation to the risk premium alpha source (which, again, encompasses value). Furthermore, this alpha source is primarily dedicated to two managers—a deep value manager and a relative value manager. We currently have an additional 10% allocation to the selection alpha source, which is dedicated to a small/mid cap strategy, as we seek additional alpha through investments in mid-cap and more liquid small-cap companies. While these stocks have been underperforming against their larger peers, mean reversion suggests that snap back is likely (see Exhibit 4).

Why we Keep the Faith

We know investors are losing faith in value. But value investing requires patience in order to be rewarded.

We also stand by our research indicating that value generates long-term outperformance relative to broad equity markets. Almost by definition, value companies are smaller from a capitalization perspective as their stock prices are trading at a discount (in terms of their fundamental valuations relative to broad equity markets). Investing in smaller companies is also a hallmark of active management, and our managers certainly exhibit smaller-sized holdings than their benchmarks.

After assessing the current market environment, we remain firm in our belief—based on our research and empirical evidence—that, historically, value offers attractive long-term outcomes. We intend to maintain our stance until a shift in sentiment lifts value—which, in our opinion, is inevitable.

Definitions

Alpha: Alpha refers to returns in excess of the benchmark.

Alpha Source: Alpha source is a term used by SEI as part of our internal classification system to categorise and evaluate investment managers in order to build diversified fund portfolios. An alpha source is the investment approach taken by an active investment manager in an effort to generate excess returns. Another way to define an alpha source is that it is the inefficiency that an active investment manager seeks to exploit in order to add value.

Price-to-Book Ratio: A stock’s capitalization divided by its book value, where book value is the value of an asset as it appears on a balance sheet, equal to cost minus accumulated depreciation. The value is the same whether the calculation is done for the whole company or on a per-share basis.

Price-to-Earnings Ratio: Equal to market capitalization divided by after-tax earnings. The higher the price-to-earnings ratio, the more the market is willing to pay for each dollar of annual earnings.

Standard Deviation: Statistical measure of historical volatility. A statistical measure of the distance a quantity is likely to lie from its average value. It is applied to the annual rate of return of an investment, to measure the investment’s volatility (risk). Standard deviation is synonymous with volatility, in that the greater the standard deviation the more volatile an investment’s return will be. A standard deviation of zero would mean an investment has a return rate that never varies.

Index Definitions

The Russell 1000 Index includes 1,000 of the largest U.S. equity securities based on market cap and current index membership; it is used to measure the activity of the U.S. large-cap equity market.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 Index companies with lower price-to-book ratios and lower expected growth values.

The S&P/TSX Composite Index is representative of large Canadian companies. It comprises roughly 70% of the total market capitalization on the Toronto Stock Exchange and includes about 250 companies.

The S&P/TSX SmallCap Index is representative of smaller Canadian companies. It includes about 200 companies listed on the Toronto Stock Exchange.




















Important Information

SEI Investments Canada Company, a wholly owned subsidiary of SEI Investments Company, is the Manager of the SEI Funds and SEI Portfolios, an asset allocation service, in Canada.

The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the Funds or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security, derivative or futures contract. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. There is no assurance as of the date of this material that the securities mentioned remain in or out of the SEI Funds.

This material may contain “forward-looking information” (“FLI”) as such term is defined under applicable Canadian securities laws. FLI is disclosure regarding possible events, conditions or results of operations that is based on assumptions about future economic conditions and courses of action. FLI is subject to a variety of risks, uncertainties and other factors that could cause actual results to differ materially from expectations as expressed or implied in this material. FLI reflects current expectations with respect to current events and is not a guarantee of future performance. Any FLI that may be included or incorporated by reference in this material is presented solely for the purpose of conveying current anticipated expectations and may not be appropriate for any other purposes.

Information contained herein that is based on external sources or other sources is believed to be reliable, but is not guaranteed by SEI Investments Canada Company, and the information may be incomplete or may change without notice.

Index returns are for illustrative purposes only, and do not represent actual performance of an SEI Fund. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index.

There are risks involved with investing, including loss of principal. Diversification may not protect against market risk. International investments may involve risk of capital loss from unfavourable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments and the use of an asset allocation service such as the SEI Portfolios. Please read the prospectus of the SEI Funds and the Underlying Funds in which investment may be made under the SEI Portfolios before investing. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer, they are not guaranteed. There can be no assurances that a money market fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Mutual fund values change frequently and past performance may not be repeated.