Value style is poised to outperform, CI manager says

When interest rates rise, says Roger Mortimer, the tide will turn against expensive growth stocks.

Michael Ryval 1 October, 2015 | 5:00PM

Stock-market sentiment will shift in favour of value stocks after the U.S. Federal Reserve raises its federal funds target rate, says Roger Mortimer, lead manager of the $4.9-billion CI Harbour Growth & Income.

The U.S. economy is improving, says Mortimer, senior vice-president at Toronto-based CI Investments Inc. Yet deflationary forces are creating an uncertain global environment. In Mortimer's view, the Fed's Sept. 17 decision to leave its benchmark rate unchanged is a signal that "it's not quite an all-clear message."

Nevertheless, a rate hike is inevitable and the pace of further increases will depend on the global recovery. "We are in a wait-and-see situation where the Fed wants to communicate that things are OK and getting better, but not at such a rate that it needs to do anything too hasty."

If Mortimer's prediction comes true, a shift away from growth stocks would be a welcome development for him. A value manager, he focuses on cheap stocks that offer downside protection.

Over the very long haul, observes Mortimer, value investing outperformed growth in the U.S. between 1975 and the present by a 2.29% compound annual growth rate (CAGR). And, significantly, in five of the eight five-year periods, value investing outperformed, he adds.

However, value underperformed in certain periods, such as the Internet bubble in 1995-1999, when the CAGR gap was six percentage points, and since 2010 when it has been two percentage points.

"The common element in both periods was excess liquidity," says Mortimer. "That's when growth outperforms. But in the subsequent period, value comes back strongly."

For instance, during the so-called post-quantitative-easing period between 2008 and today, value generated a 10.2% CAGR, well short of the 16% produced by growth investing. However, in 2000-07 and before quantitative easing (QE), value investing generated a 7.5% CAGR, versus growth which had a 4.6% CAGR.

So the tide will turn, argues Mortimer, and the main cause will likely be that growth stocks become very expensive and investors gravitate to value stocks, which have become very cheap. "It's difficult for a growth investor to argue the logic of putting another marginal dollar into a growth stock at a high valuation," says Mortimer. "They arrive at a point when they can't help but notice that those things on the other side of the table are exceptionally cheap."

"The question might be, is QE a contributor to the outperformance of growth stocks? I believe that it has been," says Mortimer, adding that excessive liquidity causes investors to be less discriminate in how they spend their cash and thus chase stocks that appear to have the highest returns.

"In an environment where liquidity is abundant and money is cheap, it may be allocated with somewhat less discipline than when money is expensive. In an environment where liquidity is contracting and money is more expensive, investors are more discriminating about allocating it. They care more about valuations."

Indeed, even though investors in Canada have flocked for two years to growth stocks, Mortimer believes the phenomenon will run its course. "The sustaining logic of buying expensive stocks becomes one where there is more risk than there is perceived return. Then investors look at a value stock and say, 'This is so inexpensive that I don't need a lot of things to go right to make it a great decision.'"

Mortimer has long been on that page, and he has lately taken advantage of market volatility. When global markets were in turmoil last August, he increased positions in  Apple Inc. (AAPL) and  General Electric Co. (GE) In the case of the former, he had reduced it in the second quarter because the valuation was too high. When Apple's stock price slumped in August, Mortimer bought back in. "The valuation was actually cheaper than when we bought the company the first time in the spring of 2014."

Turning to GE, Mortimer says the company is going through a major restructuring that will take another 18 months or so to complete. When its stock fell during the market gyrations, Mortimer added to the position.

"When you look at what the company will look like when it's completed its transformation, it trades at a significant discount to its industry peers. We think that discount will close," says Mortimer. "In the meantime, we're getting a 3.6% dividend and are benefitting from the appreciation of the U.S. dollar. But our horizon is longer than one year. The best is yet to come from this investment."

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Apple Inc236.28 USD0.43
General Electric Co8.96 USD-0.88

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Michael Ryval

Michael Ryval