Like a presidential candidate with no populist appeal, value stocks have had a tough time of it in 2015. Through September, value shares, as measured by the Russell 1000 Value Index, are lagging the S&P 500 Index by 3.67% and trailing the Russell 1000 Growth Index by more than 7%.1
Value stocks tend to be found in financial and other cyclical sectors. Financials and utilities sectors have fared the worst thus far in 2015, while less-defensive consumer discretionary sector shares have performed somewhat better.1
Investors tend to embrace value stocks because they believe the shares are trading inexpensively relative to a company’s intrinsic value; the belief is this disconnect will eventually lead to excess returns as market participants recognize a stock’s value and drive up its price. In theory, a stock’s ability to undergo “mean reversion,” or a move toward its intrinsic value, shouldn’t be affected by cyclical economic swings. But this often happens, nonetheless.
Reasons for value stocks’ underperformance in 2015
Why have value shares continued to struggle even in light of an improving economy?
-Interest rates. Value stocks tend to find favor when interest rates are rising. This makes sense when you consider that rates often rise behind strong economic growth, which typically benefit cyclical sectors like energy, industrials and financials. We have been in a zero interest rate environment since 2008, but given the correlation between value shares and interest rates, it would stand to reason that value shares could benefit should the Federal Reserve decided to take a less accommodative approach to monetary policy.
-Industrial production. The performance of value stocks has traditionally shown strong correlation to industrial output. The chart below shows the ratio of the Russell 1000 Value Index to the Russell 1000 Growth Index relative to US industrial production.
Here you can see that value lagged into 1990, 2000 and 2008. These periods all have a common denominator in that they were marked by recession. The relationship between value and industrial output isn’t perfect. Sometimes it is muted with a lead or a lag, but the historical weakness of value stocks around contracting industrial production is clear. While the US economy has technically been out of recession for more than six years, industrial production has been hindered by a strong dollar, weak growth in emerging markets and high inventory levels.
-Inventory overhang. Inventory is closely related to industrial production. In fact, the inventory-to-sales ratio has historically been a predictor of industrial production growth. Firms with excess inventories will typically try and clear out this overhang before making investments to replenish it. As depicted in the chart below, US inventories are at their highest level in nearly five years, but the inventory-to-sales growth rate has recently shown signs of cresting. This should eventually bode well for capital spending levels.
Economic conditions look to favor value shares
It’s been a rough ride for value investors, but there is reason for optimism. Within the consumer discretionary sector, analysts surveyed by Bloomberg are expecting strong third-quarter earnings growth from retailers and automakers to the tune of 14.0% and 30.2%, respectively, while the real estate industry is expected to provide a boost to financial stocks.1 And while the Federal Reserve passed on hiking interest rates during the last meeting of the Federal Open Markets Committee (FOMC), the FOMC reiterated the need to hike rates when it sees further improvement in the labor market. Over time, a strong economy tends to see higher rates and benefits defensive sectors like financials and deep cyclicals.2
As for industrial production, there is hope that it, too, will increase, as the lagged impact of a higher dollar wanes and the growth rate of the inventory-to-sales ratio shows signs of peaking. Lower inventories should lead to increased production, and value shares will likely perform better when industrial output growth moves higher, in my view.
Investors looking to increase their exposure to value shares may want to consider making a move now, before interest rates rise and investors drive up value share prices. Of course, talk with your financial adviser about your situation before making any investment decisions.
The PowerShares Dynamic Large Cap Value Portfolio (PWV) tracks the Dynamic Large Cap Value IntellidexSM Index, which focuses on large- and mid-cap value companies, while the PowerShares BuyBack Achievers PortfolioTM (PKW) holds securities issued by companies that have shown a propensity to buy back shares – a value-oriented strategy by its very nature. In addition, the PowerShares FTSE RAFI US 1000 Portfolio (PRF) provides access to value-oriented companies.
1 Bloomberg L.P., Sept. 18, 2015. Past performance is no guarantee of future results.
2 Board of Governors of the Federal Reserve System, Sept. 17, 2015
Important information
Correlation is the degree to which two investments have historically moved in relation to each other.
Intrinsic value represents the inherent business value of portfolio holdings during a two- to three-year investment horizon, based on their estimates of future cash flow.
The Russell 1000® Value Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of large-cap value stocks.
The Russell 1000® Growth Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of large-cap growth stocks.
The NASDAQ US BuyBack Achievers Index™ comprises US securities issued by corporations that have effected a net reduction in shares outstanding of 5% or more in the trailing 12 months.
The FTSE RAFI US 1000 Index is designed to track the performance of the largest US equities selected based on four fundamental measures of firm size: book value, cash flow, sales and dividends.
The Dynamic Large Cap IntellidexSM Index is a modified equal dollar weighted Index designed to identify large cap stocks that have capital appreciation potential using a proprietary stock selection and portfolio construction methodology. Each quarter 100 stocks are selected from a subset of the 250 large cap stocks of the Intellidex universe of 2,000 largest stocks by market capitalization of US companies on NYSE MKT, NYSE and NASDAQ.
Investments cannot be made directly into an index.
Shares are not individually redeemable and owners of the Shares may acquire those Shares from the Funds and tender those shares for redemption to the Funds in Creation Unit aggregations only, typically consisting of 50,000, 75,000, 100,000 or 200,000 Shares.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Underlying Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.
Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
PWV:
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
Investing in securities of large-cap companies may involve less risk than is customarily associated with investing in stocks of smaller companies.
PKW:
Investments focused in a particular sector, such as consumer discretionary, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
The Fund is non-diversified and may experience greater volatility than a more diversified investment.