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For some, value investing has been left for dead after years of underperformance. However, Goldman Sachs says there's still life left in the classic factor strategy, especially with the Fed set to cut rates again.
Goldman says the stage is set for value stocks to come back in favor: The valuation gap between expensive and cheap stocks is now the widest in nine years, which has historically foreshadowed strong performance for value names, according to Goldman's chief U.S. equity strategist, David Kostin.
"A wide distribution of price-to-earnings multiples has historically presaged strong value returns," Kostin said in a note Friday. "However, a rotation into value stocks would require a sustained improvement in investor economic growth expectations, potentially driven by global monetary policy easing."
Blame long periods of ultra-low interest rates or disruptive technology that has led most of the decade-long bull run. Value investing has gone out of style especially as the economic expansion gets stretched longer. Value names continue to lag recently amid modest GDP growth with Goldman's long/short value factor falling 7% since the start of May, Kostin noted.
But the tide could start to turn slowly for value stocks as an easier monetary policy from the Federal Reserve would give a boost to growth expectations. The central bank signaled at its last policy meeting that a rate cut is on the horizon to support the economy.
"The two most recent episodes of value stock outperformance were during the 'reflationary' period of 2H 2016 and ahead of the passage of the corporate tax reform law during late 2017. Both of these periods were characterized by a surge in investor economic growth expectations," Kostin said.
For optimistic investors who want to bet on value's grand comeback, Goldman has screened for value stocks with "a quality overlay," which could carry three times the return of the typical S&P 500 firm with similar volatility.
The so-called high Sharpe ratio basket, consisting of 50 S&P 500 stocks with the highest prospective Sharpe ratios, includes laggards and value tilts by construction, Goldman said. Sharpe ratio is a measure of a stock's performance relative to its volatility. Goldman uses consensus price targets and options six-month implied volatility to measure Sharpe ratios.
The median stock in the basket has returned only 7% in 2019, underperforming the S&P 500's 18% gain this year, and it trades at a 31% discount on forward P/E, according to Goldman.
— With reporting by Michael Bloom