Market crises and macroeconomic recessions typically create fertile ground for value stocks to outperform in a recovery. Our research suggests that higher-quality stocks with strong profitability credentials can deliver even better results after a crisis.
Since value stocks are widely perceived as higher-risk assets, they typically benefit from risk-on market environments after a market shock. Value stocks are also more prevalent in sectors that are more sensitive to macroeconomic cycles, such as industrials or materials, which tend to shine when GDP growth recovers. Indeed, the Russell 1000 Value Index surged by 37.9% from November 2020 through April 2021, as COVID-19 vaccine rollouts inspired confidence in the nascent recovery.
However, after value stocks underperformed in the second quarter, some investors wonder whether the value recovery has run its course. We think there’s more to come, and a focus on high-quality stocks should be particularly rewarding over time.
Quality Focus Bolsters Return Potential
To gauge the potential, we looked at five major shocks since 1990, when the market fell by at least 10% from the beginning to the end of a quarter. In each, we analyzed the performance of US value stocks, defined by the tercile of companies with the highest free-cash-flow (FCF) yield, as well as the highest-quality group within that tercile, based on the FCF/assets ratio. Performance was measured over a two-year period, beginning six months before the market trough to account for the fact that it’s almost impossible for investors to time a downturn or inflection point with precision.
On average, value stocks returned 14.4% annualized (Display, left). By adding a quality filter to that group, shown in the uppermost bar, investors would have enjoyed a 15.9% annualized return over the same period. Both groups outperformed the Russell 1000 Index, which was flat on average. What’s more, volatility for the highest group was also slightly lower than the market on an equal-weighted basis, meaning investors’ risk-adjusted return would have been better too.
More to Come?
So, how have higher-quality value stocks done so far in the COVID-19 recovery? Today, relative returns for the highest-profitability group are still far behind the average seen in previous crises, even after the rebound earlier this year (Display, right).
To be sure, every recession and market crisis has unique features. But we believe today’s post-COVID-19 market provides a large opportunity for value investors. Value stocks still trade at a deep discount to growth peers. And there is still plenty of uncertainty about the path to normal in many industries. In this environment, we believe attractively valued companies with higher-quality businesses and sustainable cash flows are well positioned to deliver outsize returns as the world economy gradually returns to normal.
Cem Inal is Co-Chief Investment Officer for US Large-Cap Equities and Portfolio Manager for US Equity Income at AllianceBernstein (AB).
James MacGregor is Chief Investment Officer—US Small and Mid Cap Value Equities, and Head—US Value Equities at AB.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams, and are subject to revision over time.