For Value-Loving Clients, Quality Is Necessary

Nearly 10 months into value stocks' redemption story and it's clear some questions are being answered. It's also clear that some inquisitive clients may be wondering about the durability of the current value rally and when it will be time to evaluate other opportunities.

Regarding that point, history indicates value may have plenty more room to run, but that doesn't mean other styles should be ignored. In fact, value's intersection with other factors that can help advisors answer other client queries, including what's been driving the value rebound and what could be coming for undervalued stocks.

More to the point, now is an opportune time to discuss the importance of quality when evaluating the value rebound because that resurgence is being fueled in large part by low-quality fare. Quality also merits consideration because the economic cycle is moving along and that could push cyclical stocks out of the limelight, but let's focus on the junkiness of the value rally.

Why Quality Matters Now

Quality should always matter for long-term investors and the nifty thing about this factor is that the stocks that fit its bill often check other factors' boxes, including growth, value and low volatility. In fact, quality is often conflated with low volatility, which is a reminder that quality stocks are often less turbulent than those that aren't. That's meaningful against the backdrop of low-quality fare propelling value higher.

“In the recent run-up in value, the most distressed/riskiest/junkiest names have been the strongest market leaders. In the next phase of the cycle, we believe quality value companies are more likely to lead as investors become more discerning about profitability and balance sheets,” writes WisdomTree analyst Matt Wagner.

Remember what some of the worst-performing sectors were when the coronavirus bear market set in last year. Energy. Non-internet retail and real estate, among others. Those are cyclical groups – today's stars – and many members of those sectors were exposed in 2020 for carrying too much and having flimsy balance sheets. In other words, it's not surprising that the S&P 500 Quality Index gained 17.4%  last year compared to just 1.4% for its value counterpart.

Good Time for Quality Considerations

As was noted earlier, the current value resurgence is about to enter its tenth month. That's relevant because there's an important history advisors should pass on to value-loving clients. Many past value rebounds haven born with leadership from low-quality stocks and it usually takes awhile (though not a long time) for market participants to rotate into higher quality value fare. That rotation could already be underway.

“According to a recently published Citi Research report, this shift was seen in prior instances of value outperformance following the global financial crisis and the tech bubble,” adds WisdomTree's Wagner. “The change in leadership occurred approximately six months into value’s bull run. We are about six-to-nine months into the current cycle, depending on how you track it.”

With a mean reversion at play and profitability always important, advisors can guide clients through the next leg of value's upside by emphasizing quality – something patient clients will likely be grateful for in the long run.

“With that in mind, we think investors should focus on higher-quality value names. Recent returns have favored companies with low (or no) profits—the distressed value names—but history suggests profitability is an important factor for long-run returns,” concludes Wagner.

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