AllianceBernstein

The Value Returns to Value Investing

October 28, 2013

Kevin Simms

After several challenging years, it finally feels like a great time to be a value investor again. Market conditions have become much more conducive to finding undervalued, controversial stocks with long-term payoff potential. Even after this year’s equity market rally, we think the rebound in value is just beginning.

The 2008–’09 financial crisis delivered a huge shock to investor behavior. Fears of global economic collapse dominated market sentiment. Extraordinary volatility prompted investors to flee from risky stocks toward safe assets. Little attention was paid to company fundamentals, so correlations spiked as stocks generally traded in the same direction. It was a toxic environment for stock pickers like us who focus on deep-value stocks, which over the past few years have often been found at the riskier end of the equity market. (Read more: “ How to Prevent a Market Crisis”)

Things are changing. This year global equities have shrugged off geopolitical and macroeconomic threats — from the civil war in Syria to the fiscal standoff in Washington — that would have sent markets into a tailspin in the risk-averse world of just a year or two ago. Meanwhile, stock correlations have fallen much closer to normal levels, indicating that company news is driving markets once again.

This environment means that investors can successfully use research to identify cheap stocks with much better prospects than widely perceived. Value investing relies on investors’ emotions to create opportunities, yet the payoff can only come when investors realize they have overreacted to bad news and reprice a stock accordingly. This behavior typically comes in response to some stock-specific good news, such as a positive earnings announcement. This reaction did not occur in the anxiety-driven market following the financial crisis, but it is happening today.

We think the recovery of value stocks is still in its infancy. Our measure of the value opportunity looks at spreads between the cheapest and most expensive quintiles of global stocks based on their price-to-book-value (P/B) ratio. Even after this year’s equity rally, these spreads remain very wide (see chart 1). Spreads probably have not narrowed as much as might have expected because the market dislocations created by the financial crisis were so profound. The lingering distortive effects of the safety trade left defensive, low-risk stocks at near-record premiums to the market and riskier, cyclical stocks at near-record discounts.

In the past, when these spreads narrowed, value stocks outperformed strongly. Yet by the end of September, P/B spreads had narrowed only about 12 percent of the way toward a typical trough, meaning this trend is likely to continue. Our research shows that unlike seemingly safer low-beta stocks, low P/B stocks have low correlations with bond returns, so cheaper stocks should continue to outperform in a rising interest rate environment.