Valuation dispersion in domestic shares is nearing record levels as Australia approaches its tenth year of a bull market, meaning the conditions for value investing to outperform could be near, according to a new white paper from Perennial Value Management (Perennial Value).
The white paper; Time to shift gears from Momentum to Value Investing, notes that the top quintile of Australian shares are currently trading at a price-to-earnings ratio 40% higher than their long-term average, compared to the bottom quintile of shares which are trading very close to their long-term averages.
These divergence levels are higher than those seen in the global financial crisis (GFC) and approaching those of the early 2000s dot-com boom, meaning market dynamics are likely to shift in favour of value stocks, according to Perennial Value Managing Director John Murray & Director Portfolio Management Stephen Bruce.
“Previously when valuation divergences have reached this level, there has been a reversion – often an aggressive one – towards cheap value stocks and away from expensive growth stocks. In both instances, solid and stable value companies outperformed significantly as the former market darling growth stocks fell from grace,” Mr Murray said.
The white paper argues that the years since the GFC have been characterised by low economic growth and low interest rates, meaning investors have been less concerned with the time value of money and prepared to pay more for growth stocks even through their cash flows are further away.
Mr Murray said that with growth returning to the broader economy and interest rates rising, investors’ preference was likely to swing towards value investing as it had in the past, as paying such a high premium for growth would no longer make sense.
“Although every new situation is different, it’s worth remembering that while history doesn’t always repeat exactly, it usually rhymes. With a generally improving earnings growth outlook and rising interest rates, we see an inflection point in the rate cycle where the era of easy money is largely over and the conditions for value to outperform could be near,” Mr Murray said.
As this inflection point approaches, Perennial Value sees fertile ground when it comes to investment opportunities in the local market, with a range of good quality Australian companies offering strong balance sheets, attractive dividend yields and reasonable medium to long term prospects.
“We believe it would be prudent for investors to lock in profits from growth and momentum stocks and rebalance some of their portfolio towards value,” Mr Bruce added.