Investor Bill Miller was the guest on the most recent episode of Barry Ritholtz’s Masters in Business podcast, which I listen to regularly. I found his insights about the behavior of so-called “value” stocks very helpful, which is why I’m sharing them here. I transcribed this first quote, below, from the podcast, so it’s not 100% precise. The emphasis (in bold) is mine.

Value has led out of every recession from as far back as the data goes. And the reason for that is that when the economy peaks and goes down, value companies tend to be more cyclical and their return on capital drops and so their theoretical valuation drops and the stock underperforms. When we come out of a recession, their return on capital rises, because they are more cyclical than a Coca-Cola or an Amazon, and so they outperform.

Bill talks more specifically about value stocks in the context of the current pandemic in his 1Q 2020 Market Letter. Here, he explains why value got hit the hardest during the market meltdown that occurred in late March:

Prices and valuations are highly sensitive to the marginal return on invested capital and to business risk. When the economy is declining, or there are fears that it will, valuations on those companies whose return on invested capital (ROIC) is most sensitive to economic change (mostly traditional cyclicals) will decline more than those that are more resistant such as consumer staples, utilities, bond proxies, and many recurring revenue businesses. Companies with high debt leverage and economic sensitivity fare the worst as the market discounts the possibility they will experience financial distress. When the market sees a recovery, the exact reverse occurs, which is what we saw in the week ending April 10, one of strongest weeks in market history.

He continues (emphasis mine):

Listening to the financial commentators on CNBC and elsewhere, I hear many, if not most, of them advising investors to use the decline to “upgrade” their portfolios. They say to “buy quality names on sale,” but avoid or reduce exposure to names that are riskier. Typical issues in the quality bucket include companies such as Alphabet, Disney, Nike, Amazon, Facebook, Procter & Gamble, and Clorox. Now these are all very fine companies and we own several of them. I think, though, that a portfolio comprised of all “quality” names, names that have been among the best performers in this dramatic decline, will almost certainly be a portfolio that underperforms the market as the economy and the market recover. In big market declines, the prices of stocks fall more rapidly than long-term business values. We try to use these opportunities to “upgrade” our portfolios as well, by which we mean replace names that have held up reasonably well with those whose price declines now offer much greater long-term upside when the economy comes back.