FORESIGHTLong read

What’s next for Value?

2023 was a difficult year for portfolios that focus on high-quality value stocks, but history demonstrates the potential benefits of a long-term commitment to this approach.

02-21-2024
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Read full reportQEP: What's next for Value?
6 pages

Authors

Schroders QEP Investment Team

For the better part of the last decade there was only one game in town as investors focused on growth stocks that grew ever more expensive. After a short reprieve in late 2021 through 2022, this trend repeated once again through 2023 as a winner takes all market was led by the “Magnificent 7” in the US. Consequently, the nascent recovery of value stocks stalled out over the past 12 months when looking at global equities, resulting in wider than normal discounts for value stocks compared to the market and versus growth stocks. The valuation spread between US and International equities also expanded, primarily driven by multiple expansion in US equities, coupled with the lopsided returns from the “Magnificent 7.”

Multiple expansion for US stocks, led by the “Magnificent 7”

What's next for value - Figure 1&2

Source: Datastream Refinitiv, MSCI, S&P. Showing data from January 2005 to December 2023. Forward price-to-earnings (P/E) numbers are based on the 12 months forward price-to-earnings ratio for the respective indices. S&P 500 premium represents the percentage difference between the S&P 500 and MSCI ACWI ex-USA indices. Data based on estimated future earnings which may not be realized.

Outside of the US, participation was broader, with value stocks modestly outperforming the market. And while international stocks trade at a steeper discount to the US than normal, what is perhaps more interesting is the wider discount of value stocks versus their own history within the international equity space. The current forward P/E level for MSCI ACWI ex US Value trades at a 14% discount versus its 20-year average, as depicted in Figure 3. At the same time, the spread between value and growth stocks remains quite substantial on both earnings and book value. (See Figures 3 and 4.)

International value stocks are trading well below their historical averages

What's next for value - Figures 3&4

Source: Datastream Refinitiv, MSCI. Showing data from June 2003 to December 2023. Forward price-to-earnings (P/E) and price to book numbers are based on the 12 months forward price to earnings & price to book numbers for the respective MSCI indices. Data based on estimated future earnings which may not be realized.

Most regional equity returns were driven by multiple expansion in 2023 as investors waged a tug of war between “higher for longer,” the timing of peak rates and an inevitable Fed pivot. Emerging markets absorbed the biggest earnings contraction last year, mainly led by a disappointing year in China. The US delivered a very mild earnings recession, something that feels contradictory when viewed beside the strong performance of US equities, which has relied on expectations for future growth versus present realities.

Figure 5: Rising valuations were behind US performance in 2023

Earnings growth was actually stronger in Japan and Europe

What's next for value - Figure 5

Past performance is not a guide to future performance and may not be repeated. Source: LSEG Datastream, MSCI and Schroders Strategic Research Unit. Data to 31 December 2023 in US dollars.

The last couple of years has made plain the problems with attempting to forecast. After consensus pessimism over the global economy and corporate earnings last year, both fears that failed to materialize, it is emerging markets and the US where earnings are expected to rise sharpest in the coming years. In the case of the US, stronger earnings expectations provide some support of richer valuations, which begs the question of whether we’ll see follow through with the bar set so high.

Figure 6: Earnings are forecast to rebound in 2024-2025, especially for Emerging Markets and the US

Consensus forecasts of corporate earnings by region

What's next for value - Figure 6

Forecasts included are not guaranteed and should not be relied upon. Source: LSEG Datastream and Schroders Strategic Research Unit. Data to 31 December 2023.  Notes: Japan EPS for 2022 is 4 quarter sum until March of next calendar year, e.g. 2023 = 3/31/2023 – 3/31/24.

With a meaningful Fed pivot priced into markets after a robust  Q4 2023 rally, it is informative to unpack how value stocks have fared in declining interest rate environments historically. We analyzed how frequently value or growth outperform the broader market when short- and long-term rates move higher or lower, evaluating all monthly observations back to 1997. Conventional wisdom would say growth wins in a declining-rate environment, while value wins in rising-rate environments. Somewhat intuitively, growth has “won” more consistently over this period within the ACWI ex US index, primarily driven by its advantage during declining-rate periods.

However, this is only part of the story; valuation levels matter in such an exercise. When the same analysis is run conditioning for expensive market level valuations at the starting point, the results are different – value stocks perform better on a relative basis when short and long rates decline in the ACWI ex US space, as depicted in Figure 7. As Figures 3 and 4 illustrated, valuation levels are broadly expensive across non-US equities at the moment, particularly when you strip out value stocks. This sets up for potentially better relative performance from value as rates decline going forward.

Figure 7: In the aftermath of relatively expensive valuations, value stocks have historically outperformed when rates decline

Style win rates with expensive valuations at the starting point, for MSCI ACWI ex US

What's next for value - Figure 7

Source: Datastream Refinitiv, MSCI Past performance provides no guarantee of future results and may not be repeated.

So, what’s next for value? Broadly speaking, value stocks remain attractive and well positioned looking out over the next 12 months, particularly outside of the US. In fact, wide valuation dispersion has resulted in an abundance of opportunities, and one could argue that this breadth of cheap valuations outside of the US is indicative of a wide array of distressed opportunities but not necessarily distressed companies (Figures 8 and 9).

A breadth of cheap valuations outside the US

Forward price-to-earnings ratios compared to history

What's next for value - Figure 7

Source: MSCI, QEP in USD as at December 2023. Based on MSCI World Universe. Forward P/E data is density weighted, meaning that the weights of future years are taken dependent on analyst dispersion and counts, sourced from QEP systems, averages based on the monthly data going back to 1986. Buckets show market-cap percentages. Past performance is no guarantee of future results.

Given the breadth of opportunities, a couple of areas that we would highlight include cheap quality defensives and SMID caps more broadly, with the caveat of being vigilant against value traps.

Lastly, from a thematic standpoint,  secular trends around deglobalization, demographics and decarbonization may be more supportive of non-US and value-oriented securities than the market regime of the prior decade. High level thoughts from Schroders pertaining to the possibility of a “3D reset” can be found here: Three trends are reshaping the economy. What investors need to know.

As the landscape for value opportunities remains fertile, how best to capitalize? Recent performance trends arguably set the stage for better results from a diversified approach.

A diversified Value solution for a changing market

The “Magnificent 7” effect stands in marked contrast to the longer-term pattern of affordable high-quality companies outperforming their peers. Indeed, Value investing has a well-established pedigree that extends back over a century. The source of the Value premium is often driven by investors chasing short term winners while ignoring more compelling longer-term opportunities elsewhere.

Quality is a critical but often overlooked aspect of Value investing. Broadly speaking, it captures the fundamental strength of a business by assessing the stability of its profitability and whether it employs excessive financial leverage. It is further complemented by determining the sustainability of its growth and corporate governance standards. Warren Buffett summed it up well: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” A good long-term investor understands there is often a trade-off between Value and Quality - acknowledging that value traps (companies that are cheap for a reason) can materially impair performance and valuation alone cannot support an investment thesis. Historical evidence reveals it is better to pay a slightly higher valuation for companies with much stronger fundamentals, and it is fundamentals that define how truly attractive a stock is from a valuation perspective.

Figure 10 illustrates the long-term performance of non-US stocks when split into cohorts of both Value and Quality as defined by the QEP team at Schroders. As noted earlier, the best returns over time have come from cheap companies that also offer stronger quality characteristics.

Figure 10: For non-US stocks, inexpensive quality has historically delivered the highest – and most consistent – returns

Long term returns and win rates (1990-2023)

What's next for value - Figure 10

The return may increase or decrease as a result of currency fluctuations. Past performance is not a guide to future performance and may not be repeated. Source: Schroders QEP. Data to December 2023. Each month all stocks in QEP’s international (ex-US) mega to mid-cap universe are ranked using QEP’s value rank and quality rank. Terciles of the value rank are used to classify stocks as cheap, market like or expensive, while terciles of the quality rank are used to classify stocks as high, moderate or low quality. Market capitalization-weighted portfolios are rebalanced monthly and US$ returns are calculated with transaction costs taken into account. A maximum stock weight of 3% is applied within each portfolio. Annualized excess returns are then calculated against a market capitalization-weighted universe.

The QEP Value framework incorporates multiple facets of Value and is constructed according to four key pillars, each containing a range of underlying fundamental metrics to generate a holistic view of what makes a stock attractively valued. The four Value pillars include earnings, cash flows, assets and dividends. The QEP Value strategies are exceptionally diversified across these pillars, as well as by stock, industry, country and theme. This diversification element reduces the risk of a narrow market environment significantly dominating relative performance, an important feature amid such an uncertain backdrop at present.

A key differentiator of our Value investment process is the systematic inclusion and assessment of a company’s business quality profile, with financial strength and stability a key focus. We seek cheap stocks with a focus on those with the strongest quality characteristics, that is, fundamentally attractive companies underappreciated by the market. Figure 11 illustrates the key aspects of our Value and Quality frameworks.

Figure 11: The fundamental drivers of the QEP stock selection framework

What's next for value - Figure 10

Source: Schroders. The views shared are those of the Schroders QEP Team and may not lead to favorable investment outcomes.

The thoughtful blend of these clear measures of Value can deliver a more powerful and consistent return experience versus reliance on single or narrow definitions of value. Effective implementation and bespoke modelling are important, however, as not every industry is the same. Figure 12 illustrates the persistent outperformance of our combined QEP Global Value model as well as the underlying pillars that make up our value assessment:      

Figure 12: Historical returns demonstrate the benefits of focusing on our four components of value

Relative performance of value components

What's next for value - Figure 12

Source: Schroders QEP. Annualized monthly relative returns versus a global universe return for top quintile (Cheap) and bottom quintile (Expensive) of combined Global Value Rank and four underlying models. Largest 8000 stocks globally, data from 1996 to December 2023. Equal weighted returns and rebalanced monthly. Past performance provides no guarantee of future results.

It is important to note, however, that narrow definitions of value can periodically deliver outsized relative performance over short-term time horizons. In fact, our differentiated approach to value investing has been somewhat challenged over the past 18 months. Figure 13 highlights that cheap low-quality stocks have intermittent periods of outperformance, which tend to be heavily influenced by low price-to-book stocks performing well. These trends typically occur during early cycle recovery periods in the market. Over the long run, low price to book is the least effective single valuation view, which helps inform the deficiency of cheap low-quality stocks versus cheap high-quality stocks.

Figure 13: Cheap low-quality non-US stocks have historically intermittent periods of outperformance

ACWI ex US: 2-year rolling relative performance, cheap high quality vs. cheap low quality

What's next for value - Figure 13

Source: Schroders, QEP. Data from January 2004 to December 2023. Mega to mid-cap stocks are taken based on an ACWI IMI universe, excluding United States and Undeveloped/Frontier Markets. The QEP Global Value rank is used to classify stocks as cheap, market like or expensive, while the QEP Global Quality rank is used to classify stocks as high, moderate or low quality. Inclusion in each relevant bucket is dependent on reaching a certain threshold of the ranks (25% / 50%). Stocks are weighted based on market capitalisation, with weights capped at 3% within groups. Returns are based on monthly data and rolling data is cumulative and has not been annualized. Past performance is not a guide to future results.

Drilling in further, cheap low-quality stocks have materially outperformed cheap high-quality stocks in non-US developed markets in recent months. This is a departure from the results of the long-term study illustrated in Figure 10, which showed that cheap high-quality stocks have outperformed with a higher win rate than other segments of the market. However, over the past 18 months, the opposite has occurred, as shown in Figure 14.

Figure 14: A recent reversal of the long-term trend for non-US stocks: Cheap high quality has underperformed cheap stocks of lower quality

Returns of ACWI ex US – July 2022 to December 2023

What's next for value - Figure 14

Source: Schroders, QEP. Data from July 2022 to December 2023. Mega to mid-cap stocks are taken based on an ACWI IMI universe, excluding United States. QEP Global Value rank is used to classify stocks as cheap, market like or expensive, while the QEP Global Quality rank is used to classify stocks as high, moderate or low quality. Inclusion in each relevant bucket is dependent on reaching a certain threshold of the ranks (25% / 50%). Stocks are weighted based on market capitalisation, with weights capped at 3% within groups. Returns are based on monthly data and are relative to the universe. Past performance is not a guide to future results and may not be repeated.

While the low-quality cohort of value occasionally shines, over the long run these periods are short lived and the group underperforms higher quality parts of value. In fact, per QEPs analysis, since 2010 low quality deep value stocks underperform the investment universe by -2.7% with a win rate of only 45%, representing an unreliable segment of the market.

Diversified value approach poised for recovery

2023 was a challenging relative performance year for value managers that systematically incorporate quality characteristics within their investment process, and the QEP International Value strategy was not immune. However, the value opportunity remains quite healthy in non-US equities, and the attributes we seek in compelling portfolio candidates have only become more attractive in recent months. In fact, a favorable byproduct of the current environment is that the quality of value within our portfolio is superior than it has been in the past.

On a related note, value performance in 2021 coming out of the pandemic, through much of 2023, was primarily driven by cyclicals/re-opening stocks but today the opportunity set is more balanced, which is reflected in the portfolio’s positioning. We are avoiding some of the deep value stocks given the still elevated level of uncertainty in the market about a global slowdown. In other words, we don’t have to scrape the bottom of the barrel to extract value, which is particularly fortunate against the backdrop of a potential slowdown.

Most importantly for our approach, the intersection of Value and Quality in non-US markets could potentially offer higher relative returns versus the market over the next three years when compared to simply buying Value alone, assuming everything reverts to its long-term average (see Figure 15). In short, we believe the value opportunity remains broad, and we are well placed to capitalize looking forward.

Figure 15: The best opportunities over the next three years could be in cheap, high quality stocks

The MSCI All Country Word ex USA Investable Market Index: Region and sector neutral expected return over the next three years, assuming normalization to long run.

What's next for value - Figure 15

Source: QEP, IBES, data from January 1997 to December 2023. Value/Quality basket is formed of the stocks in both the top third of the QEP Global Value rank and the Global Quality rank. Expected return assumes normalisation of forward price/earnings over the next three years. The forward price/earnings numbers are based on constructed portfolios neutralised by QEP Business Model and QEP Region, the growth in EPS numbers are based on the constructed portfolios. The views shared may not lead to favorable investment opportunities. Expected returns are not guaranteed. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

As participation inevitably broadens across the value space, we believe the time-tested tenets of our diversified value approach are poised for recovery.

Important Information

All investments, domestic and foreign, involve risks including the risk of possible loss of principal. The market value of the portfolio may decline as a result of a number of factors, including adverse economic and market conditions, prospects of stocks in the portfolio, changing interest rates, and real or perceived adverse competitive industry conditions. Investing overseas involves special risks including among others, risks related to political or economic instability, foreign currency (such as exchange, valuation, and fluctuation) risk, market entry or exit restrictions, illiquidity and taxation. These risks exist to a greater extent in emerging markets than they do in developed markets.

The views shared are those of the Schroders QEP Team. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice. Information herein has been obtained from sources we believe to be reliable but Schroders Plc does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. This document does not constitute an offer to sell or any solicitation of any offer to buy securities or any other instrument described in this document. Past performance is no guarantee of future results.

Read full reportQEP: What's next for Value?
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Authors

Schroders QEP Investment Team

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