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Is 2021 going to be the year of a value rotation?

For some time now, we have been highlighting the wide valuation gap between the ‘value’ and ‘growth/quality’ ends of the market. Earlier in 2020, we suggested that the drivers of this extreme dispersion might be coming to an end and the 2020s could be the decade of the ‘cheap asset’.

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One thing we were confident about was that when a style rotation happened, it would likely be extremely sudden and powerful.

Vaccines the catalyst for value?

The optimism that greeted the good news about vaccines in November has led many commentators to ask whether this development could be the long-awaited catalyst for a style rotation.

The prospect of a return to normality means that the market can start to look forward again, it could also provide an enormous boost to economic activity and, ultimately, the start of a new economic cycle, with a positive effect on the value style, as many of the cheapest stocks in the market currently can be found among the cyclical sectors.

Should we see an economic recovery, an inflationary environment and rising bond yieldsthis year, the market rotation could be extreme, in our view. This was demonstrated in November 2020, when we saw a rally driven by cyclical stocks in response to encouraging COVID vaccine news.

Stretched valuations

We think valuations of popular growth stocks are extremely stretched and have decoupled from underlying company performance, the so-called fundamentals.

While we believe the recent vaccine-driven sector rotation has been a catalyst for a value rebound, this is not the only reason why the trend might continue in the longer term. The valuation gap between value and growth stocks has been widening for some time; however, in the past two years we have seen a big divergence between the styles, even on a sector-neutral basis – which effectively takes out the impact of sectoral features.

In our view, this last ‘stretch’ is hard to justify as being the result of structural change, and therefore we think it is likely to require less of a change of sentiment to reverse.

Our concerns about the extreme valuation dispersion in the market could be wrong and growth stocks may continue to dominate. However, we think that investors are somewhat complacent about the potential risks that some of these growth companies might face. In light of some of the extremely elevated valuations we observe, we think that we could potentially see a repeat of the crash of the highly popular Nifty Fifty stocks in the 1970s, or the burst of the dot-com bubble in 2000.

The growth style has dominated for so long now and the gap between the cheap and expensive stocks had become so stretched that we think, on a risk/reward basis a rotation towards value is likely at some point.

We are aware that there will probably be some speed bumps ahead for the rotation to value. However, we think there are many attractive long-term opportunities among cheap, out-of-favour stocks – especially companies with strong balance sheets – in different sectors, which helps diversification.

After more than a decade of style headwinds, many of our value peers have given up the fight. In our view, this and the growing influence of passive investing, has contributed to the significant growth bias in the market. According to Morningstar, only 14% of the assets in global equity funds has a value tilt. While this has been a headwind for us, we also feel that our commitment to the value style means we are well placed to benefit from a style rotation, if it happens.

Simple and repeatable process

In the M&G Value team we have always been firm believers that value investing has the potential to deliver good investment returns, provided there is a rigorous process to filter out value traps and it is afforded an appropriate investment time horizon.

Our simple and repeatable process, which combines strict valuation screening and rigorous fundamental analysis, has the potential to identify attractive value opportunities, as well as reducing the risks that are associated with investing in cheap, out-of-favour stocks.

To us as value managers, the current situation feels like a ‘once-in-a-career opportunity’. It has been a long wait for value to return to favour, but we are optimistic that our patience could be rewarded and we will see that the value style is very much alive and well.

Richard Halle , February 2021

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