Investor alert: Value investing is staging a comeback

Since 1975, in periods when earnings growth was accelerating, value plays beat growth stocks by an average of 3.2 percentage points a year.

As 2016 rang in, a bevy of Wall Street strategists made a prediction: Value investing will stage a comeback. With the first quarter now in the books, it looks like they were right.

Value investing beat growth for the first quarter of the year — rather handily in key stocks and in the exchange-traded funds that both small investors and many institutions use as proxies for style and sector bets.

Seven of the 174 value ETFs tracked by ETF Database rose by 5 percent or more between Jan. 1 and March 31, compared with none of the 96 largest-growth ETFs. Value funds tracking large-cap stock indexes did better than small-cap value funds.

A trader works on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters

As earnings season gets under way, the question is whether the value stock rally can sustain its momentum, said Savita Subramanian, chief U.S. equity strategist at Bank of America Merrill Lynch.

Optimism about earnings has risen as fears of a U.S. recession have waned. That could hold down the market overall, but the shift toward value from growth should continue, Subramanian said. "We think it's still going to be good for value. Last year earnings were down 1 percent for the S&P 500. This year, it's going to be up 2 percent-ish. So it's an improvement — one that makes the most difference for value."

The case for value is about correcting a popular misconception: Value, not growth, takes the lead when the economy and profits are growing more steadily. Since 1975, in periods when earnings growth was accelerating, value plays have beaten growth stocks by an average of 3.2 percentage points a year. When earnings are deteriorating, growth has beaten value by 3.1 percentage points annually, according to data provided by BMO Capital Markets strategist Brian Belski.

Value also beats growth when the market is coming out of downturn, even brief ones like the 14 percent correction between last May and this February in the Russell 2000 Value Index, which is the primary benchmark for small-cap value stocks. The large-cap S&P 500 Value Index was down by exactly 9.5 percent during the same time period.

That rule, reflecting both investors' preference for security in troubled times and a gradual decrease in the scarcity of companies that can provide earnings growth as the economy improves, has helped value stocks beat growth by the same 3.2 percentage points in the 12 months after each market bottom since 1995, he said. That's all the more notable, considering that growth has beaten value by 1.9 percent a year overall since then.

Year-to-date, though, the Russell 2000 Value Index has bounced around — with a net return of only 0.6 percent. But since February 11, it's notched a notable gain: near-14 percent. The S&P 500 Value Index is up 1.6 percent this year, but since Feb. 11 it's also up by a notable correction-erasing amount: 11 percent.

"Earnings from consumer staples and consumer discretionary have been very strong,'' Belski said. "Most strategists have been too macro-focused, and macro data is historical. The move to value is more about fundamentals and about what will happen next.''

So far this year, that logic has been been the best news not for broad value stock index funds, but funds that focus on dividend stocks specifically: State Street's SPDR S&P Dividend ETF (SDY) is up 9 percent. Meanwhile, iShares Select Dividend ETF (DVY) and First Trust's Value Line Dividend Index Fund (FVD) are the next best, up 8.4 percent and 7.7 percent, respectively.

Ten ETFs within the large-cap value category, as defined by, have year-to-date returns of 6 percent or greater; all are dividend ETFs. There are no large-cap growth ETFs with positive performance, according to

There are five small-cap value ETFs that have gained 2 percent or more YTD, according to; no small-cap growth ETFs have managed positive performance.

Those dividend stock fund returns are much better than the broader value stock funds year-to-date, which suffered from the volatility into mid-February.

The biggest risk to the market's move toward value may come if the expected boost in corporate profits doesn't materialize. And the continued weakness of capital markets is a concern, with the slowest market for initial public offerings since 2009 and the cost of capital for businesses rising in bond and commercial-loan markets as well.

Belski is more bullish than Subramanian in general, expecting the S&P 500 to end the year at 2100, 100 points higher than his competitor. And he speaks more confidently about the economy's pace of improvement and how it might drive value strategies in sectors like financial services and technology. Merrill is cautious on financials because of uncertainty over the pace of rate increases this year.

"The next cycle is about domestic growth, consumer growth," Belski said, and even banks will get a chunk of that, as earnings rise initially on the back of wealth-management fees and cost-cutting before interest rates rise over 12 to 18 months. "We have to focus on three to five years. Too many investors are looking three to five months, even three to five weeks."

Over that time, the trend will clearly be toward a sustained U.S. expansion and higher interest rates that will favor blue-chip financials like JPMorgan Chase and Morgan Stanley and more value-like tech companies (big dividend payers), including Microsoft and Intel, Belski said.

Year-to-date, JP Morgan is down 10 percent, but again, the performance since mid-February is another story, with the bank stock gaining close to 7 percent. Morgan Stanley is down 22 percent year-to-date, but up 8 percent since mid-February.

On Wednesday, JP Morgan earnings and revenue beat expectations even as profits dropped, and the banking sector rallied, with JP Morgan up 2 percent in early trading.

"The next cycle is about domestic growth, consumer growth. We have to focus on three to five years. Too many investors are looking three to five months, even three to five weeks." -Brian Belski, BMO Capital Markets strategist

For fund investors, the bad news about the move to value is that it's expected to be unevenly distributed. Belski sees more of a stock-pickers' market developing, as a market driven by macro themes is replaced by one where specific company fundamentals are more important. Also, sentiment-driven stocks, like Apple and Netflix, will be less favored than they are in growth-dominated markets, Subramanian said.

"If the party is back on, you'll want the cyclicals, not FANG," Subramanian said, referring to the four horsemen of the 2015 market: Facebook, Amazon, Netflix and Google, the largest unit of Alphabet. Facebook is the only of the four FANG stocks that is up year-to-date.

The Merrill strategist also likes energy and materials stocks.

Dead cat bounce?

Justin Carbonneau, partner at Validea Capital Management, said they have started to see a turn in its value models after a number of difficult years. Its ETF, the Validea Market Legends ETF (VALX), uses models based on the strategies of iconic investors and has currently tilted to seven value models and three growth models, with a specific focus on small-cap value stocks.

"Whether or not this is a true long-term reversal in value outperforming growth is yet to be seen, but there are a few reasons that make us think the turn is coming (or has already started), and when it does, value should see a significant and sustained mean reversion in terms of performance," Carbonneau said.

A big driver of value outperforming is interest rates: Value tends to do better during rising rate environments because higher rates and higher expected inflation make future cash flows worth less. Growth stocks are valued more on the future, and value stocks on the present.

Additionally, some of the cheapest stocks are in sectors that have seen dramatic price declines, like energy, or in sectors that haven't kept up with the broader market, like financials.

"If you believe valuations are a predictor of future price returns, like we do, then these are the areas of the market that will help lead the value recovery," Carbonneau said.

Even Caterpillar, one of 2015's worst blue chips, has worked this year, rising 12 percent even as concern about its business in China persists. Subramanian said Caterpillar is a classic example of an industrial value play that often beats the markets during earnings recoveries, but she couldn't quite resist a pun on the company's famous ticker symbol.

"Maybe it's a dead cat bounce," she said. "Or maybe it's a sign that the world is not as bad as people thought.''

By Tim Mullaney, special to