Deep-value stocks could be on the verge of a turnaround

Value investing has underperformed lately, thanks to monetary policy. That could change, and soon

A Xerox employee slices open a pellette of their product

A Xerox employee slices open a pellette of their product. (Daniel Acker/Bloomberg/Getty)

Many investors are getting reacquainted with that panicky feeling they felt back in 2008. One type of investor, though, may be welcoming the correction. Deep-value buyers—people who look for stocks that are trading at a large discount to what they appear to be really worth—have had a rough go over the past few years. The TWM Deep Value Index, which includes 20 undervalued dividend stocks, such as Xerox Corp. (NYSE: XRX) and Halliburton Co. (NYSE: HAL), has fallen 11.3% since September 2014. Many other stocks considered deep value, such as Staples Inc. (Nasdaq: SPLS) or Reitmans (Canada) Ltd. (TSX: RET), have dropped dramatically as well.

The underperformance is widely attributed to the efforts of central banks to inject liquidity into the markets since the recession. When markets rise across the board, value stocks tend to suffer, says Timothy Rankin, a portfolio manager with Franklin Templeton Investments. People look for companies that are keeping pace, not ones that are trying to turn themselves around.

In a down market, by contrast, investors start paying attention to the stocks that are already beaten up, Rankin says. Value stocks trade at a discount to their peers or their past valuations, so they don’t have as far to fall in a correction. And when they do finally demonstrate sustained earnings growth, the discount shrinks. The upside can be huge.

In fact, value stocks have outperformed growth stocks over time by around three percentage points, and broader indexes by 50 to 100 basis points annually, says Eric Kirzner, the John H. Watson chair in value investing at the University of Toronto. That’s partly due to reversion of the mean, he says, which is the idea that depressed stocks eventually return to their true value.

Value stocks also languished during the Internet-obsessed bull market of the late 1990s. When tech went bust, value came back into style. Kirzner expects value stocks will have a similar moment in the near future.

Right now the energy sector, and commodities in general, is littered with deep-value opportunities. A lot of good companies have been beaten down because of the low price of oil. Dependent as these outfits are on a commodity price out of their control, though, investors have to be extra patient. They may have to hang on for five years before seeing capital gains. However, Rankin thinks gains are generally coming faster than they used to. “Value is getting realized more quickly,” he explains. “There’s more interest from strategic and private-equity buyers, so the value is staying hidden for less time now.”

Choosing deep-value stocks can be tricky. You can fall into a value trap, where the stock price never recovers. So investors must determine the reason the stock has fallen in price and whether its fundamentals still look attractive. When it comes to deep value, as opposed to just value, the catalyst for improvement is often not clear, says Rankin. Maybe another company will buy a part of the business, or its legal issues will be settled or its balance sheet is strong enough to ride through a financial downturn. “You have to have some ideas around how the value could be realized, but it may not be immediately clear how it will happen,” he says.