Value Stocks, and the Appeal of Index Dropouts

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I see several reasons to pivot towards value. One is the elevated inflation risk. The other is the elevated macroeconomic risk. Value stocks do better in a recession and slowdown than growth stocks, and much better than growth stocks in the early stages of a recovery once a recession or slowdown is winding down.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Rob Arnott. He's the founder and CEO of Research Affiliates, an asset manager. Rob's going to tell us about the risks facing investors now and how they should be positioned, and he's going to discuss his recent research on what happens to stocks after they get kicked out of indexes. Good things, it turns out, on average anyhow. We'll talk about it. Listening in is our audio producer Jackson. Hi Jackson.

Hi Jack.

I'm going to read something to you. This is a little blurb from BMO Capital Markets. It says, as consumers traded department stores for e-com, e-commerce, off-price has gone from stigma-filled to a proud destination, and TJX has been at the forefront with comp and store growth offering customers and brands a compelling offline marketplace to move goods in a post-department store world. That says we still expect TJX to compound as it becomes a more important part of the retail ecosystem. Now TJX, you familiar?

That's, uh, TJ Maxx and Marshalls.

Marshalls and HomeGoods.

HomeGoods, yeah.

And some other brands. And you heard the term comp, that's short for comparable store growth. In other words, the company is growing both by adding stores and by increasing its sales at existing stores. You also heard the term off-price, which of course refers to discounting, but I don't think of it as your regular discounting, like, hey, we're running a 30% off pants sale right now. I think of it more as, hey, we found a huge stockpile of pants that someone else couldn't sell, so we bought them for 30 cents on the dollar, and we're gonna sell 'em to you for 60 cents on the dollar. And we're not going to lie to you, maybe they have 3 leg holes, but, you know, also they could be perfectly fine.

You got to figure it out for yourself.

Yeah.

What would you do if you found a shipping container filled with pants? Where are they finding these?

Increasingly from department stores, which is how BMO described it here. We're in the post-department store world, as they say. So department stores find themselves increasingly with stock that they can't sell. Then they turn to off-price retailers like TJX. To take it off their hands, and TJX stocks their stores with it, but opportunistically. So you don't get the same things every time you go in stores. I mean, some of the stuff is the same, like basics, but you get different deals every time you go in. And people call that a treasure hunt environment, and customers like it. And TJX has this army of buyers who go around and find these good deals. What I'm curious about is the way BMO has characterized it here, how It's gone from stigma-filled to a proud destination. Was it stigma-filled?

I find that offensive.

When was it shameful to shop at TJX? I don't remember that.

I went stigma-free.

My understanding is that people do it fairly gleefully. They love finding deals. And I have read anecdotal evidence of some pretty fancy cars in the parking lots over at TJ Maxx stores. So I don't think it's just strapped consumers that are going after those deals. Anyhow, TJX seems to be doing well.

I was just at Marshalls this weekend. I don't, I don't understand how they can support half their store just filled with Halloween decor. Like, are they people who will switch their sheets and, and picture frames and couch cushions and dish towels and bathroom towels to seasonal versions of all those things every single season?

Well, I can tell you what we do in my house is We go all out for each holiday once, and we buy a lot of decorations.

We do—

we go, you know, one Halloween we go all out with like skeletons and cobwebs and Styrofoam tombstones and everything like that. Then we pack it all away and we put it in the basement, and then we never use it again.

So it's just every holiday gets one shot and then we're over it.

I mentioned TJX because they had an earnings report this week and it was well received. That stock went up 6%. Management said that it was off to a good start in the third quarter. They raised their full-year guidance. BMO says, we continue to favor TJX given our multi-year belief in its increasing importance to consumers and more importantly to brands as it continues to capture market share and global growth. Okay, they raised their price target to $133. The stock was already about $120 and change at the time, so they see potential for about a 12% return. No big whoop, I know, but Target also reported and that stock went up 11%. I'm looking at the take from Jefferies on Target. It says consumer remains choiceful, but traffic comps are driving growth. There's those comps again. Jackson, you feeling choiceful these days as a consumer?

I use that word to describe my feelings all the time.

Choice-ish.

Choice-ish.

Yeah.

I'm feeling cautiously choice-omistic myself. Jefferies mentions top and bottom line results ahead of street estimates. Top line meaning revenues, bottom line meaning profits. On a list of things Jefferies liked about the quarter, they list strong top line performance, improving margins, Apparel witnessing continued strength, that's good, and profit guidance raised. On the list of things it didn't like about the quarter, it said nothing. It said this was a strong print. As for the long-term opportunity, Jefferies writes Target has a clean inventory position, it's continuing to lap temporary margin headwinds. In other words, things maybe weren't so good a year ago, which means that the numbers they have to beat are modest. And so beating them is easy, which makes them look good. It says the company recently announced price reductions, which could drive improved comps and has witnessed benefits from Target Circle. Target Circle is a rewards program. Jefferies nudged its price target up to $195 from $190. The stock after the jump on earnings was recently about $159. And so what do these two have in common? I guess that shoppers are still buying, but they're looking for deals. Is that what we take away from this, Jackson?

I, I guess it's a question, right? Are people turning away from higher-end retailers?

You know, my colleague Andrew Barry mentioned that last week on the Barron's Roundtable TV show. By the way, there's a show called Barron's Roundtable. It's on each Friday, Saturday, and Sunday. It airs a bunch of times on Fox Business, and I've been hosting it the past couple of weeks, and I'm going to host one more show this coming weekend. So if you're it the past 2 weeks. I had a beard and spoiler alert, this week I don't have a beard and that's just because it looked like Rat Fur.

I actually had, I didn't forward it to you, but we had, we had some listener feedback.

What did you, what was the feedback? Tell me.

Let me read it.

Uh, oh gosh.

I don't want to know. I, I don't want to out this, uh, this person here.

Go ahead. Go ahead.

Uh, can I give him one piece of advice? If he's going— if he's going to go beard, he's got to shave under his jaw and his neck. It'll make him look more polished, like the guy on his panel tonight.

Too much neckbeard is a very nice way of saying it.

A little too much neckbeard.

All right.

Well, that's constructive.

I'm not a regular beard guy, so I didn't know how much. I don't know where—

where do you put the line?

I didn't know.

That was after they said you're very good hosting Fox Business.

Yeah, yeah.

No, no, no. You're not going to—

you're not You're not going to win me back now. I'm going to cry myself to sleep tonight thinking about my neckbeard.

Anyhow, Andrew Barry on the show last week was talking about a little bit of softness at the high end. He mentioned luxury brands, including LVMH, the company that makes Louis Vuitton. He also mentioned that European Wax Center. Remember that company?

Not—

that's not car waxing. That's body waxing.

They had a monthly subscription service.

I don't really know how it works. Is that, uh, is what— is waxing a higher income thing?

I think you have to have some disposable income to sign up for the monthly waxing.

Yeah.

And if you don't, if you don't, what are you doing? Is there a TJ Maxx of, uh, wax? Is there a TJ Wax?

I think there's a great opportunity there.

But what's the value route?

Uh, tin foil and wood glue.

No, no, no, no, it's not.

No, it's not, everyone. All right, the important point here, don't listen to what Jackson said. Is that investors are responding favorably to retailers that are getting it right on value right now. And Target seems to be recovering nicely after a stumble. Let's get to my recent conversation with Rob Arnott of Research Affiliates. I asked Rob about how he thinks the stock market looks now, including the Magnificent Seven, where he sees value, and about his recent research on what happens to stocks when they fall out of indexes. Let's jump into that conversation.

I love finding asymmetries in the markets. I love finding situations where prices are set based on consensus expectations. Those consensus expectations are often right. Narratives that define markets are often right, but there are often asymmetries in the risk. Inflation's a beautiful example, uh, breakeven inflation rate. For 10 years is 2.1%. So the market is pricing TIPS versus Treasuries, uh, so that at 2.1% inflation, the two both have the same return. All right, well, there should be some sort of symmetry around that. Maybe 1% overshoot versus 1% undershoot should be about equally likely. If you ask 100 people, do you think 3.1 is more likely than 1.1, you'll find Hmm, 95 out of 100 will say, yeah, yeah, inflation surprising to the upside is more likely than inflation surprising to the downside. That kind of asymmetry has value. It creates opportunity. So an ability to find investments that will do well if inflation is higher than expected or lasts longer than expected, that's a good way to capture that asymmetry. There's also an asymmetry on the macroeconomy. We have, uh, 4 strong predictors of economic slowdown, uh, that are currently flashing amber. You've got yield curve inversion, which has been talked about endlessly. The, the notion that, uh, the spread between 3-month T-bills and 10-year bonds has been negative for a long time, and has historically a perfect track record picking 9 out of 9 recessions with no false positives. Well, that's pretty cool. Rate of change of the cost of capital over the last 3 years, uh, is in its worst decile ever. The PMI is in its worst quartile ever.

I wanted to spell out the acronym for folks who aren't familiar— Purchasing Managers Index.

Purchasing Managers Index, exactly right. And the SOM Rule looks at, uh, rolling 3-month unemployment rates because one month is a little noisy. And if you're more than half a percent above the lowest level of three-month average unemployment of the last year, the SOM rule is triggered. And the SOM rule doesn't predict recessions. It says you're already in a recession. So that rule is saying we're in a recession now. 5 out of 5 are signaling amber. The market has shrugged that off, partly based on expectations of Fed easing, Fed stimulus, and partly based on a wealth effect from equity bull market, and partly because of spending, consumer spending. I like to say that in the pandemic, people started spending like there's no tomorrow because they thought there might be no tomorrow. In the aftermath of the pandemic, it's hard to change those spending patterns and cut back on spending when you're used spending more than you have, and the result is soaring consumer debt and so forth. So there's an asymmetry on the economy. The economy has done reasonably well over the last couple years. And so the question, the question is upside surprise versus downside surprise. The narrative is soft landing might happen. No landing is even more likely. No landing meaning no slowdown anyway. Soft landing being a slowdown or a recession. Our models suggest 75% likelihood of slowdown or recession.

So these are two things that you see as being more likely than is built into the math right now. And so what, what would an investor do about those if, if higher inflation is more likely than the bond market says? I mean, an investor could buy TIPS, I, I guess. Is there, is there something else that that you see as a good opportunity for them to prepare for that?

We like to describe markets in terms of 3 pillars for successful investing. First pillar is mainstream stocks to participate in macroeconomic growth. Second pillar is mainstream bonds to provide reliable real income and to tamp down the risk of the portfolio. Most people have those first 2 pillars pretty well covered. The third pillar is diversifying markets that are only lightly correlated with mainstream stocks and bonds. And that tend to do well when inflation surprises to the upside. That'll include obvious inflation hedges like TIPS, commodities, and REITs. It'll also include stealth inflation fighters like emerging market stocks and bonds and high-yield bonds, which for entirely different reasons all tend to do better when US inflation is surprising to the upside. Third pillar investing's fallen out of favor the last dozen years because we've had a rip-roaring bull market. And one of my colleagues likes to describe diversification as a regret-maximizing strategy. In a roaring bull market, you regret every penny you've got in diversifiers. And when that bull market grinds to a stop, you regret every penny you don't have in diversifiers. So decade of the '90s, diversifiers were awful. Decade of the 2010s, diversifiers were awful. Decade of the 2000s, diversifiers were brilliant. '70s and '80s, diversifiers did very nicely. So are we likely to enter a repeat of the last dozen years, or are we more likely to see a reversal of fortune? History suggests that mean reversion is one of the most powerful engines in the capital markets. So for elevated inflation, the obvious choice would be put more money in diversifiers. Within the stock market, inflation surprises work to the detriment of, uh, growth and betterment of value. If you have elevated inflation, you have most likely elevated interest rates. When you have elevated interest rates, the discount rate for calculating the net present value of future growth goes up. Meaning that the net present value of future growth goes down. Now, the other asymmetry, the asymmetry in the stock market, can we go from solid growth to startling growth, or can we go from solid growth to slowdown or recession? There's an asymmetry there too. 90 out of 100 people would say suddenly turning on the spigots and having startling growth is less likely than a slowdown, given that consumers are stretched thin, given that the economy is showing signs of slowing. My hope is that those 5 measures that are flashing amber all turn before consumers run out of their spending power. I'm not sure that's going to happen. And if it doesn't, then the risk of a recession becomes real. A hard landing is not off the table.

This is the second, as you call them, risk asymmetries that you spoke about. The first one was inflation. And I, and I thought, okay, Rob's going to tell me about some good inflation hedges. But the second one is you see a greater chance of a recession, it sounds like, than financial markets have priced in, which leaves me thinking, well, what do we do about that? Do we just, do we bail out of stocks altogether? Do we run for the hills? Or—

There, once again, some measure of diversification makes a lot of sense, but It also enters the picture in a very powerful way in value relative to growth. So I see several reasons to pivot towards value. One is the elevated inflation risk. The other is the elevated macroeconomic risk. Uh, uh, value stocks do better in a recession and slowdown than growth stocks, and much better than growth stocks in the early stages of a recovery. Once a recession or slowdown is winding down. So we're looking at a period of time, the next year and a half or 2 years, in which I think value can shoot the lights out. The third reason to love value right now is that it's so out of favor and so cheap. What do I mean by that? Back in 2007, the spread in valuation between growth stocks and value stocks Relative price earnings ratios, relative price to book, relative price to sales ratios was about 3 to 1. It went to 9 to 1 in the summer of 2020 after the COVID uh, value crash. Now, what does that mean? That means that value stocks relative to their underlying fundamentals fell by two-thirds when compared to growth stocks. So the entire underperformance of value during that bleak 13.5-year span was predicated not on value companies doing badly, but on value stocks getting cheaper relative to their fundamentals. We're back down to a 9-to-1 spread again. We've tested that low twice, once at the end of '21 and once right now. So when you have a 9-to-1 spread, the market is basically saying these Magnificent Seven stocks, uh, are going to grow ninefold relative to the broad sweep of, um, conventional value stocks, which is where the bulk of the economy operates. Are these companies poised to grow relative to value? Highly likely. Are they likely to grow ninefold? I don't mean 9 times the growth. I mean 9-fold relative size of the businesses. Uh, are they likely to grow that much relative to, um, the value stock value companies? That seems a stretch right now. The Magnificent Seven are worth quite a bit more than the entire Chinese stock market, more than twice as much as the entire Japanese stock market, and more than the entire combination of European Union stock markets. Take all of the European Union combined. These 7 companies are worth more than all of the EU. So what that tells me is that the market believes these 7 companies will produce more profits for their shareholders in the decades ahead than the entire European economy. More than twice as much as the Japanese economy, more than the entire Chinese economy. And is that possible? Yeah, the narratives usually have an element of plausibility. Is it likely? That seems an extreme stretch.

Thank you, Rob. More to come from my conversation with Rob Arnott at Research Affiliates, including big tech antitrust and artificial intelligence and new research on index dropouts. We'll be back right after this break.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Model portfolios have evolved from a one-size-fits-all solution. In a recent roundtable conversation, Jeffrey Chris Safe of BlackRock and Alessio DeLongis of Invesco break down what's driving the next model moment, discussing how a deeper level of customization is producing a better alignment with investor goals and creating a practice differentiator for financial advisors.

Welcome back. Let's get back to my recent conversation with Rob Arnott from Research Affiliates. You have to factor in, I would think, the regulatory effect here. We just saw an antitrust ruling against Alphabet, and I tend to think of, you know, those big tech monopoly judgments as like Lay's potato chips where nobody stops at one. So we're wondering who's going to be next. There are a lot of proceedings going on. Is that— do you think that that's the kind of thing that might not be fully encapsulated in the, in the market values here?

Here's what happens when a company becomes dominant player in its industry. It comes under attack. Customers who loved getting their Amazon packages every, every day or two now find reasons to complain about Amazon. People who love the search engines from Google and admired the company now find plenty of reason to complain about them so that customers start taking potshots, regulators start trying to make a notch on their gun, competitors want to take shots, and the very business practices that propelled you to the top are suddenly viewed as predatory. So one thing that we've noticed and have documented is that top dogs don't stay on top very easily. If you look at the top 10 most valuable companies in the world in 1980, only 2 were on the top 10 list 10 years later. The top 10 in 1990, only 3 were on the top 10 list a decade later. Top 10 in 2000, only 2 were still there 10 years later. Uh, top 10 in 2010, only 2 made it to 2020. And top 10 in 2020, 4 of them are already off the list. So the rotation at the top is huge And the narrative is always that these 10 companies, each one of them is a world-straddling colossus that has a moat that has no competitors who are likely to make inroads. But, but disruptors get disrupted. People forget that the folks who coined the expression Magnificent Seven, I would guess, never saw the movie because 4 of the 7 are dead at the end of the movie.

That's a, that's a good point.

Hey, do you want to talk at all about— I saw your name attached to a study. It was interesting, this sort of quirky effect of, um, companies that fall out of indexes.

Yeah.

Well, you want to tell us about that? That was interesting.

Sure. We created an index called NIXT, N-I-X-T, for companies that have been nixed from indexes. Now, if you go back historically and look at S&P 500, Companies that are added are companies that are not large, but very popular trading at high multiples with a narrative that says this company is going places. And that narrative is often right. The companies are added when they've had stupendous momentum. They're added when they are trading at lofty, even frothy multiples. And they, they replace a company. Uh, there's several kinds of deletions. Some are corporate actions. The company gets bought out, so it disappears from the index. Forget about those ones that are discretionary deletions where the S&P Index Committee decides this stock is no longer interesting. Let's, let's replace apartment investments with Tesla. Okay, Tesla was decent-sized company trading at very high multiples. AIV was a tired, troubled apartment-based REIT company, and it was trading at deep discounts. It was deeply out of favor. Its performance had been dreadful. That's the norm for companies that are dropped. Well, would you rather buy a company with a great narrative, great story, and everyone believes its future is, is, uh, set and it's trading at frothy multiples, or a company that's deeply out of favor, dirt cheap. Well, the simple fact is the companies that are frothy and beloved, some of them go on to great things. Most don't. Most disappoint before they have the chance to turn into today's Teslas or Nvidias or Microsofts. And for every Google that goes on to great heights, there's 10 or 20 fly-by-night frothy growth companies that fail to deliver and fall off the list. Flip-flops are expensive. The committee says we're adding this stock, and then 2 years later the committee says, oops, we're dropping it. Buy high, sell low. That's not helpful. Deletions, the discretionary deletions, are dirt cheap companies, many of which are headed for oblivion. And many of which aren't. The ones that aren't are trading at deep discounts, can easily double or triple or quadruple. And there's that kind of flip-flop too. Companies that get pushed off the list and then come back on the list. Dillard's was dropped from the Russell 1000 4 times in the last 25 years and reentered the index 3 times. Sell low, buy high. Sell low, buy high. Sell low, buy high. So Why not buy a basket of all of the companies that are deeply out of favor, deeply enough out of favor to be dropped from indexes, which means horrible momentum. They've performed terribly, priced dirt cheap, underperforming for 2 or 3 years to get kicked off the index. Those are all attributes of companies that are turnaround candidates. Half of them won't turn around, but the ones that do have gains that dwarf the ones that don't. So when we went back, we looked at Russell 1000 deletions, S&P deletions, um, NASDAQ 100 deletions. So if you compare these deletions with Russell 2000 value, what you find is that the aftermath over the next 5 years after they've been deleted, on average, they outperform by 28%. That's over 5% per year compounded. Now it's a wide range. Some of them quadruple, some of them go to zero. So it's, it's a weird funky index, the NIX index, that simply looks at what companies are doing so badly that they're being kicked out. Let's, let's buy the rejects.

Is there anything I neglected to ask you about that's on your mind? I, I always like hearing about what you've been working on recently.

Oh, I think the only thing we haven't talked about where there are asymmetric risks is domestic and global politics. So, but let's not dive deep into that contentious territory other than to acknowledge that things are more likely to get crazier between now and year-end than to suddenly become placid and boring.

Oh no, I was hoping you were going to say, don't worry, we've hit peak crazy.

We have not hit peak crazy, but We also haven't talked about the AI revolution, which is very real. The fact that those stocks are frothy and in my view severely overvalued means nothing in the way of negating the importance of the AI revolution. It is going to be astonishing.

Going to be good for the economy, bad for the economy, neutral for the economy.

I think it can lay a foundation for stupendous long-term growth. Looking ahead 20 years, um, you remember that book The Singularity is Near? Okay, the singularity is near.

How long until AI takes my job? I did— now you're not going to hurt my feelings, Rob.

I've already been talking about this with my wife. I've given it like 3 years.

So how—

all 3 of us have zero risk of losing our jobs to AI. All 3 of us have a huge risk of losing our jobs to somebody who knows how to use AI better than we do. So we have to start studying. AI is a tool. It's an extraordinarily powerful tool. It's going to be smarter than PhD researchers within the next 5 to 8 years.

Thank you, Rob, and thank all of you for listening. Jackson Cantrell is our producer. Jackson, I went to a county fair this past week, the Dutchess County Fair in upstate New York. I think it's county fair season, right? There's going to be maybe some Oktoberfests coming up. There's going to be folks out there getting some funnel cakes, right?

It's funnel cake season.

And I just have a word of caution. Funnel cakes are delicious. Pay attention to wind speeds. Get a forecast and base your decision about whether to get the powdered sugar on the wind speed, especially if you're wearing a black polo shirt. You don't want to turn into the wind with your funnel cake and just end up showered by powdered sugar.

This sounds oddly specific.

Hey, look, we're trying to help all kinds of folks here. Finance, fashion, you name it.

Might be time for a trip to TJ Maxx or to the laundry room.

You can subscribe to the podcast on Apple Podcasts, Spotify, wherever you listen. You can also send us a question if you want one answered on the podcast. We're going to be doing a listener question special or two coming up in the next, I don't know, several weeks. What you do is you tape it on your phone, you use the voice memo app, and then you send that to jack.hough, that's H-O-U-G-H, at barons.com. And then you hear yourself on an episode. Folks who've had it happen to them describe it as life-changing. True, Jackson?

It's true in spirit.

Exactly.

See you next week.

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