Equities: time to rotate?

20 September 2019

5 minute read

Despite limited moves by stock market indices, so-called “value” stocks rose sharply in recent weeks as equity markets across the globe rotated between sectors and investment styles. For instance, banks and carmakers were among those sectors to profit from the rotation, performing particularly well.

Pick your style

A lot has been said about “momentum”, “quality”, “low volatility” and value styles, and why value stocks were due to for a rebound after years of underperformance. We highlighted in “Investing in a late cycle” in May that “low(er) quality” stocks could stage a short term rebound, boosted by renewed investors optimism and light positioning”. After all, this style of investing had underperformed so much that it was easy to call for a reversion to value.

But the main point is that there are as many ways to define quality as there are to explain momentum and value. Momentum stocks are those that have seen their price trend consistently up or down over a specific period of time. But this period can be a week, a month, a year or anything in between. There is no rule.

Similarly, a value stock is one that is deemed cheap on any given financial measure. This can be a price-to earnings, price-to-book or price-to-sales ratio. But if one looks deeper within each of these styles, it’s clear that large divergence exists and that not all value has outperformed nor momentum lagged (see chart).

Chart showing factor returns

Beware value traps

Many investors believe that this rotation has legs and could hurt the returns of those invested in quality stocks. We recognise that extreme positioning could cause value to outperform, at least in the short term. But we believe that chasing value is not the right strategy.

First, value tends not to remain in fashion for too long. The market is generally quick to reprice undervalued assets once a catalyst appears (in this case, an apparent détente in US-China trade tensions). If a stock remains undervalued for a while, it is probably for a good reason. In our view, many value stocks fit that description of value traps and should be avoided.

In addition, with proper value assets such as European banks having already rallied significantly from their lows, the upside now looks much more limited. On the other hand, investing in well-positioned, well-managed companies for the long-term should continue to pay dividends.

Second, value is mainly found in the most cyclically exposed parts of the market. While investors may have been too concerned about a potential recession for much of this year, recession risks have faded recently due to more accommodative central bank policy and a temporary de-escalation on the trade front.

Quality, not fashion

At this stage, the outlook for markets appears to be more aligned with sentiment, leaving little room for more positive macroeconomic surprises to boost market valuations. When recession fears eventually re-emerge, as they likely will this late in the cycle, we believe that investors will be quick to return to the perceived safety of quality stocks.

We continue to favour well-positioned, well-managed, and cash-generative quality businesses (our definition of quality) across both defensive and cyclical sectors. More than a paradigm shift, the recent style rotation to value from quality may have created an even more attractive entry point for investors to revisit those markets, sectors or stocks likely to offer better long–term prospects.