Value stocks poised to take the lead from growth investing

A looming earnings recession favors utilities, staples, dividend-payers.

At the two-month mark of 2016, the stage has been set for value over growth investing.
Think high-dividend-payers, utilities and consumer staples. Some might even call it a “Dogs of the Dow” strategy.
“I’ve been advocating a shift to value from growth for lots of reasons, because right now the valuation differential between value and growth is the largest it’s been since the dot-com bubble in the late 1990s,” said Crit Thomas, senior investment strategist at Touchstone Investments.
Measured on a price-to-book value basis, the Russell 1000 Value Index is currently at 1.67, which compares to a p/b ratio of 5.24 for the Russell 1000 Growth Index.
“If you can get these calls right, moving between growth and value, you can really benefit,” Mr. Thomas said.
In addition to the expanding valuation differential, a value tilt is also supported by the 10-year stretch for growth stocks, which typically swaps the lead with value about every seven years.
Performance-wise, so far this year, the difference isn’t all that stark.
The Russell Value Index is down 5.19% through the first two months of the year, while the growth counterpart is down 5.62%.
On a 12-month trailing basis, the value index is down 9.41%, while growth is down just 5.05%.
“Traditionally, in down markets, value funds tend to do relatively well because they include more defensive sectors, and value managers typically have some cash available, which doesn’t get hurt in a down market,” said Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ.
While market watchers and financial advisers might not see the U.S. economy racing toward a recession, it is possible that the stock market is heading into an earnings recession.
“When earnings start to turn, investors start to turn away from growth,” said Greg Estes, portfolio manager at Intrepid Capital.
He added that signs of trouble for earnings have been showing up in sluggish revenue growth that is eating into earnings.
“Top-line growth is over; that’s gone, and we’re in a challenging environment,” Mr. Estes said. “It’s on a company-by-company basis, but by and large you won’t see a lot of top-line growth, and If you can’t continue to cut expenses and top line is stagnant or declining, you’re earnings will go down. Those factors point toward value over growth.”
With top-line growth stagnant, stocks have been riding over the past few years on earnings that were largely created through cost-cutting to expand profit margins, according to Mr. Thomas.
On a trailing 12-month basis, the profit margin of the Russell 1000 Value Index is about three percentage points below its peak of 9% in early 2014, which represents a potential reversion to the upside move.
Meanwhile, the Russell 1000 Growth Index is sitting on a profit margin of 9.5%, which is right next to its early 2014 peak of 10%.
“A lot of what has been driving the stock market the past few years has been earnings growth,” said Mr. Thomas. “That earnings growth has been driven by margin expansion, not from top-line growth.”
Among the broad U.S. equity mutual fund categories, none of the nine style-boxes tracked by Morningstar is positive this year, but large-cap value is the best of the bunch with a 5.2% decline, followed by a 5.52% decline for small-cap value, and a 5.63% decline for mid-cap value.
The three growth-fund categories are at the bottom. Large-cap growth is down 8.16% this year, mid-cap growth is down 8.41%, and small-cap growth is down 10.66%.
The sector-fund categories expected to benefit the most in a more favorable market for value investing include utilities, up 2.95% this year, and consumer defensive, down 1.3%.
“With concerns that the U.S. economy might be slowing and the Federal Reserve less likely to be raising rates regularly in 2016, consumer staples and utilities stocks have been among the stronger performers this year,” Mr. Rosenbluth said. “These kinds of stocks tend to have more stable revenue streams regardless of macroeconomic data and offer above-average dividend yields.”