The time for value investors is coming... maybe

Value investors, the true pessimists of the investment world, are struggling to find contrarian views in the more than six-year bull market.

But with the Federal Reserve poised to finally raise interest rates later this year, they're hoping their period of underperformance will soon come to an end.

They say the first rate hike — be it in September, October or December — could mark the bottom of the cycle, correcting overblown valuations and, they hope, triggering a return to an investment style that focuses on finding shares trading for less than their intrinsic values.

“When interest rates rise, value tends to outperform,” said Dylan Ball, Edinburgh-based executive vice president and portfolio manager for Franklin Templeton Investments' global equity group. The money manager has $866.5 billion of assets under management.

“When interest rates fall, then the value index underperforms. There is some correlation going on here between bond yields and value performance,” he said.

Since 1995 (the inception of the value index), the correlation between monthly returns of the Russell 3000 Value index and moves in 10-year U.S. Treasury yields was 0.3; compared to 0.24 with the Russell 3000 index over the same period.

Other money managers agreed, including Laurence Bensafi, London-based deputy head, emerging markets equities, at RBC Global Asset Management. “We think (the interest rate hike) could be one of the turning points. That in the past has been a point (of change) — people are worried about the Fed moves, and then realize it is not the end of the world, and the economy improves,” she said.

RBC GAM has C$370 billion ($283.5 billion) in AUM.

It cannot come soon enough. Fewer opportunities and relative underperformance of value stocks vs. other investment styles, such as growth, has led to some serious underperformance of indexes, and by the managers investing in that style.

Since the bull market in U.S. equities began in March 2009, the MSCI World index has outperformed the MSCI World Value index by 64 basis points annually. The difference in U.S. equities has been even more pronounced, as the Russell 3000 has outpaced the Russell 3000 Value index by 96 basis points annually.

According to the S&P Dow Jones U.S. S&P Indices Versus Active Funds Report, as of year-end 2014 78.6% of large-cap value funds underperformed the S&P 500 Value index in the year. Data show 73.6% of midcap value funds underperformed the S&P MidCap 400 Value index in 2014; and 94.3% of small-cap value funds failed to beat the S&P SmallCap 600 Value index.

“The past few years have been tough for stock pickers, and it is a tough time for value,” said Tim Edwards, senior director, index strategy, at S&P Dow Jones Indices in London. “So value managers are suffering from two problems — it is really hard to be an active manager, and hard to be a value manager.”

The effects have also been felt by true value investors, such as Aberdeen Asset Management, which suffered £9.9 billion ($15.6 billion) of net outflows — with £4.5 billion of those net outflows from equities alone — in the three months ended June 30. Those outflows, coupled with market movements, led to a 7.6% decrease in assets under management, to £307.3 billion at June 30.

“Our equity process is still out of favor, and obviously will lead to underperformance, and that has continued certainly for the first two months of the quarter,” Aberdeen CEO Martin Gilbert said in an analyst call on July 23. “We are struggling (because) we are not momentum investors — we invest in quality companies. I'm not pretending it isn't painful at the moment.”

At an Aberdeen-hosted conference in May, Mr. Gilbert reinforced the firm's commitment to its value style. “Whatever we do, we must not cut at the point of maximum pain,” he said.

While money managers are looking toward the Fed and the U.K.'s Bank of England for a rate hike, they also need to see a “return to rationality” for value to outperform once again, said Jason Hsu, co-founder and vice chairman at Research Affiliates LLC, Newport Beach, Calif.

“What will lead to value outperformance will be a price correction — the start of the bear market, which will correct” much of the overblown valuations seen in recent years in particular, said Mr. Hsu. He agreed the macro catalyst for a turn in this value cycle will most likely be a U.S. rate hike.

“We are 6½ years into a bull market,” said Mark Wynne-Jones, portfolio manager of Investec Asset Management's global value equity strategy in London. “There is a similar feeling to where we were in 2006-"07. Back then, again, we were struggling to come up with a decent new vintage of cheap stocks. What caused that to change was a lot more volatility in the market, and markets that were unkind in an absolute sense, which threw up better opportunities for us.

“But there is an element of being careful what you wish for,” Mr. Wynne-Jones said, referring to the 2008 financial crisis.

Investec has $120 billion of assets under management. He summarized the value investment opportunity and those that search for it as “glass-half-empty people — they get excited when markets are falling, and vice versa.”

For value to do better, one sector in particular needs to improve, said Kurt Umbarger, portfolio specialist covering T. Rowe Price's global value strategies, in Baltimore. “Financials constitute (about) 31% of the global value indexes. If they continue to underperform the likes of health care, then value probably will continue to have a pretty big headwind. In our view, increasing with optimism, financials are still an area with value, and their fortunes we think will change as we go through the next 12 months.” The firm has $773 billion of assets under management.

What these money managers really want is a return of dispersion, the variance in returns among stocks. “The most critical thing, and what I would love to see, is value dispersion coming wider,” said Ian Butler, portfolio manager for J.P. Morgan Asset Management's European strategic value strategy in London. “History has shown that the best time is when it is at its widest — currently it is more in line with the long-term average, at best.”

The return of dispersion will see the market correct its views of companies that are value opportunities for the right reasons, vs. those that are value traps — and are cheap because they should be.

“We need capital to replenish into the unloved sectors of the previous bull market,” said Franklin Templeton's Mr. Ball.

Not surprisingly, some institutional investors appear to have fallen out of love with value.

Data from eVestment LLC show a suffering in particular for U.S. value funds, with $22.3 billion of outflows from U.S. large-cap value strategies in the three months ended June 30. Net outflows were $410.4 million that same quarter in 2014.

Net outflows in global all-cap value strategies in eVestment's database slowed to $2.4 billion in the quarter ended June 30 compared to $3.5 billion in the previous quarter. However, in the three months to June 30, 2014, these strategies recorded net inflows of $2 billion.

However, Peter Laurelli, New York-based vice president and head of research at eVestment, noted pockets of interest, either driven by one particular fund, such as inflows to U.S. midcap value equity funds of $730.2 million over the three months ended June 30, or regional shifts. Funds tracked in eVestment's All Countries World Index ex-U.S. large-cap value equity database attracted $662.8 million of net inflows, building on seven consecutive quarters of net inflows.

Once the tide does turn for value, the beauty of the style is that it is “persistent,” said JPMAM's Mr. Butler. “When the value style works or doesn't work, it does so for a sustained period of time.”

Mr. Hsu added that now is exactly the time institutional investors should be staying true to any value-style equity allocations they have.

“The performance of value is quite cyclical. It is like a spring — if you press lightly, the spring bounce is not very powerful; but if you press it further and firmer, then you get a much stronger spring-back. The longer value has underperformed, the stronger the performance after that,” he said.

Data Editor Timothy Pollard contributed to this story.