The first half of 1999 has seen what can only be described as the revenge of the value investor. Val...
The first half of 1999 has seen what can only be described as the revenge of the value investor. Value stocks have outperformed the FTSE All-Share by on average 25%. So, after years of struggle why has this style done so well? A primary reason has been what we have termed the 'Lazarus effect'. Many value cyclical stocks were priced for dead at the end of last year by investors bruised by falling markets, the Russian default, hedge fund calamities and fears of global deflation.
The US and other central banks moved quickly to return a measure of stability to world stock markets and as a consequence, by the start of this year the storm clouds had at the very least receded. Against this background, value stocks rebounded from depressed levels.
The extent of the rebound can be seen in the numbers. The steel sector has outperformed the broad UK index by over 65% in the first half of the year alone, with no material change in earnings forecast. The rerating in the forestry and paper sector has been even more profound with a similar outperformance seen against the background of further earnings downgrades.
As the world pulled back from the brink of disaster the desperate flight to quality, which had pushed up growth stock valuations as 1998 drew to a close, abated. Growth stocks suffered from the 'Icarus effect' as overbought stock prices unwound. Furthermore, profits were there to be taken.
For example, the previous darling of the stock market, the pharmaceuticals sector, has underperformed by over 25% this year reversing gains in 1998. This is despite continuing to produce steady double digit profits growth. So looking forward, value stocks will enjoy sustainable share price recovery only if their earnings growth outlook improves.
There are several positives. Commodity industries will benefit as global growth leads to a more balanced supply/demand dynamic. Commodity price rises so far this year have been dramatic, with oil increasing from $10 to $18 a barrel. The restocking effect ahead of the millennium is likely to boost volumes, prices and therefore earnings, not only in oils but in a range of commodity industrial areas such as steel, paper and heavy end building materials.
The Far East is recovering and data seen in the IFO European survey indicates European growth of roughly 2% to 2.5% for this year. Even Japan's outlook looks better with its key economic Tankan survey also beating expectations. With the UK and US maintaining their positive momentum, it looks as though all the major blocks of the globe will be growing together at a reasonable rate for the first time in many years.
The extent to which companies benefit from the recovery in global demand is going to depend on product and price. Globalisation and free trade have stimulated intense competition across borders. Furthermore, a low inflation environment has made it increasingly difficult for companies to improve profits by merely raising prices.
Given this outlook we believe stock market winners will be found in both the growth and value camps, but superior earnings growth is the key.
Those cyclicals with profits geared to the recovery in UK and world growth will prosper. Clear likely winners are commodities and basic resources. The outlook for exporters is less clear cut and currency remains a key negative. Within the growth universe, ratings there have to be justified by earnings growth prospects. The superiority of the high growth areas of telecoms and IT bodes well for their performance.
John Griffiths is deputy head of UK equity retail funds at Henderson Investors
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