While value investing didn’t enter a “new era of outperformance” in 2017, investors could be unprepared if the style does return to favour, according to Kepler Trust Intelligence’s Alex Paget.
The research analyst said the argument for value investing last year was based on the belief that gilt yields would continue to trend upwards as inflation picked up in the UK. 
However, yields fell from a peak of 1.54 per cent at the end of January 2017 to 1.26 per cent by the end of the year – around a 20 per cent fall – said Paget (pictured).
“We don’t claim to be experts in global fixed income markets, but the commonly-held view among those who do is that bond yields will rise over the coming years,” he added.
Having outperformed the growth style in 2016 for the first time in several years, value returned to underperformance in 2017.
As the below chart shows, the MSCI United Kingdom Growth delivered a total return of 12.79 per cent compared with a gain of 10.72 per cent for the MSCI United Kingdom Value index.
Performance of indices during 2017
Source: FE Analytics
Paget said outperformance of the growth index could be attributed to its constituents, which include defensive consumer staples stocks such as British American Tobacco, Unilever, Diageo and Reckitt Benckiser.
With stable growth and reliable dividends, these stocks have been used as ‘bond proxies’ by investors looking for attractive yields.
“As such, when bond yields have fallen, these stocks have tended to perform well,” he noted.
Conversely, previous research by Kepler had shown that when 10-year gilt yields had risen by more than 30 per cent over the past 20 years, the MSCI UK Value index had – on average – almost quadrupled the returns of the growth index.
Paget said: “The general drop in yields quite clearly had an effect on the performance of UK value stocks, whose performance to the MSCI UK Growth index was closely correlated to the performance of 10-year UK gilt yields.”
The fall in gilt yields last year did seem difficult to justify against the macroeconomic backdrop, Paget said, but stemmed from “the odd position the UK finds itself in”.
“While the US seems to be on a path to normalisation on the back of sturdy economic growth, a precarious political backdrop and economic uncertainty created by the EU referendum appear to have taken a toll,” he explained.
Paget said the Bank of England had found itself put in a difficult position since the EU referendum, with the central bank forced look past the impact of sterling weakness on inflation.
Indeed, the central bank had been forced to keep rates lower for longer rather than raising them too quickly and potentially killing off any recovery in the UK economy.
It remains difficult to forecast short-term movements in bond markets, with many having failed. Yet, Paget said it was “sensible” to suggest yield would rise from current levels over the medium-term, highlighting forecasts by investment bank Nomura International that yields would end the year at around 2.5 per cent.
10-year UK government bond yields over 5yrs
Source: Bank of England
If yields do rise there could be far stronger monetary tightening than many expect, which in turn should benefit value stocks, said Paget.
As such, he said the research house is sticking by its value call as “one of the most effective ways for investors to shield themselves from further bond market routs”.
The Kepler analyst said it was surprising, however, how little exposure UK investors have to the value style with more inflows heading to funds with a clear growth or quality bias.
He said just 29.8 per cent of capital invested in actively-managed equity funds from the Investment Association universe and 28.01 per cent in the investment trust universe was in value strategies.
“You could argue this is understandable as, apart from 2016, growth strategies have tended to considerably outperform more value-orientated funds,” he said.
“This is shown by the fact that, across the 20 largest equity funds in the IA universe, just 22.5 per cent is invested in value stocks.
“That list of funds includes quality growth offerings such as Fundsmith Equity, Morgan Stanley Global Brands, Jupiter European and LF Lindsell Train UK Equity.”
He added: “The most important part, however, is that investors continue to pile into funds that have been prime beneficiaries of the conditions that have driven markets since the global financial crisis, rather than looking at areas that could perform well if those dynamics do indeed begin to change.
Source: Kepler Trust Intelligence
“For example, across the 10 most bought active equity IA funds, just 16 per cent is invested in value stocks.”
Paget said: “As such, it appears the ‘average’ UK investor is wholly unprepared for a resurgence in the value style.
“While that may not happen over the course of the next 12 months or so, it is clear that there is greater need for style diversification within portfolios, especially as value has underperformed growth and other investment styles of such a long time.”
“I can now trace back five years of market commentary that has warned that shares of the sort we invest in, our strategy and our fund would underperform,” the FE Alpha Manager said. “During that time the fund has risen in value by over 175 per cent.
“The fact that you would have foregone this gain if you had followed their advice will of course be forgotten by them if or when their predictions that our strategy will underperform the ‘value’ strategy of buying cyclicals, financials and assorted junk pays off for a period.”