Value stocks have a history of lagging growth stocks during the early and middle parts of an economic cycle. Growth stocks show stronger earnings growth earlier on and investors are willing to pay a premium for that. However, in the later part of the cycle when demand increases, capacity becomes constrained, commodity prices rise, inflation creeps up and interest rates increase, it becomes value’s time to shine. This develops into a very fertile environment for value stocks to show dramatic increases in earnings and for its assets to appreciate. Value then tends to outperform growth, sometimes quite dramatically, in a rising interest rate environment. We believe that we are nearing that time frame now and are positioning portfolios to reap the benefits of this transition.
Our recent strategy
We have been building positions of iShares Russell 2000 Value ETF that not only focuses on over 1,300 value-oriented stocks, but specifically small cap companies with an average market cap of $2.7 billion. These companies will not only benefit from domestic economic forces in play, but because of limited exposure to international markets, we expect them to outperform their heavily trade-dependent counterparts. This is evidenced in the Russell 2000’s rather extreme divergence from the Dow Jones with regards to year-to-date returns.
The Dow was down 1.8% YTD, while the Russell 2000 was up 7.0% for the first half of the year. This is partly due to the fact that roughly 50% of the revenue for the Dow is derived domestically while for the Russell it’s closer to 80%. Focusing on domestic revenue growth allows us to tune out some of the noise generated by trade war fears and currency fluctuations.