Views from the CIO: Does the Recent Value Rally Have Legs?

Value investing has been out of favor relative to the growth-style orientation over the last three years; the MSCI World Value Index is up 10.9% versus the MSCI World Growth Index up 22.9% in net U.S. dollar terms as of February 29, 2016. As a result, we have seen valuation spreads widen significantly, particularly in energy and materials sectors, as well as certain emerging markets reflecting earnings troubles and potential bankruptcies. In other words, markets did not want this bankruptcy risk and de-rated this group of stocks. However, not all stocks within this “deep value” group will go bankrupt, which creates an opportunity for stock pickers.

To identify these valuation opportunities, we monitor “valuation spreads”, which is the valuation difference between the least and most expensive group of stocks in the market. This is similar to the credit spread analysis in fixed income: when spreads are very wide, the opportunity in risky assets is high. Similarly, when these valuation spreads are very large, it means there is a “value” opportunity in the market: a signal that value style will likely outperform in the next 12 months.  When speaking to the wide valuation spreads, this is being seen within book value and cash flow factors.  At the beginning of the year, we identified that certain areas in global markets have reached historically wide valuation spreads with particular extremes being seen in Canada and commodity-related stocks and countries.  Consistent with the theme of “less bad news is good” thus far in 2016, we have witnessed a recent outsized rally in the previously out-of-favor commodity-oriented stocks globally beginning in late January.  Alternatively, after significant outperformance, investor sentiment toward high-growth, high-momentum stocks have moderated.  Volatile, negative momentum stocks within the energy and materials sectors have been at the peak of the recent turnaround.

Previously we had noted that companies with significant share price weakness or low momentum looked attractive from a valuation standpoint but was without a fundamental catalyst to underlying earnings support.  However, we have now come to an inflection point as catalysts have surfaced in the form of favorable currency, notably the moderating strength of the U.S. dollar, and commodity price movements which are now introducing the upside to earnings, relative to beaten-down expectations in the previously shunned commodity-oriented and emerging markets stocks.  Furthermore, market expectations on viability of most commodities companies had deteriorated to capitulation levels but the recent movement from “bad” to “less bad” represents an important source of “positive” fundamental change now.

We understand the current interest in value stocks may moderate in the short-term, however we believe the “value” opportunity will still be present in the market. The interest in “value” will likely continue through this year, with reversal rallies as we observed in February, until the valuation spreads moderate. This could mean ultimate value outperformance. Certain countries and sectors offer better opportunities to harvest this value risk premia. For example, Canada is one we’ve highlighted below.  Within the chart, you can see the cheapest group of stocks within the Canadian universe (10%) is as cheap as we have ever seen.  This development presents a potential opportunity for upside to returns over the coming 12 months.

Past performance does not guarantee future results

Past performance does not guarantee future results

These value opportunities in Canada and emerging markets are even greater than what we saw during the financial crisis in 2009! Even though these areas offer the most opportunity, there are still fundamental and macro-economic risks that make this call a difficult one. We see importance in having fundamental stock picking and portfolio exposure to both value and growth characteristics in this risky environment – the magic is in the mix….

…Click here to continue reading




Follow Principal Global Investors on LinkedIn

The information in this article has been derived from sources believed to be accurate as of March 2016. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

The information in this article contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.

Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions in this article. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account.

Third party content, such as comments to this blog, is not reviewed by Principal Global Investors before it is displayed, although we may remove, alter, edit or adapt any such comments. Principal Global Investors does not endorse, authorize, or sponsor any third party content. Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided.

Investing involves risk, including possible loss of principal. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards. Risk is magnified in emerging markets, which may lack established legal, political, business or social structures to support securities markets.

Principal Funds are distributed by Principal Funds Distributor, Inc.