With investors wondering whether value’s outperformance of the last two years can be sustained, Ben Arnold looks at three key questions at the heart of the debate.
Lowly valued stocks trumped those with higher growth potential by a significant margin in 2022. The MSCI World Value Index outperformed the MSCI World Growth Index by 23%.
This was the second consecutive calendar year where value outperformed growth, having underperformed in seven of the previous eight years by 128%. This led many to pose the question “Is value investing dead?”. Value acolytes will hope that the better recent performance means 2020 marked the investment style’s nadir.
The big question for equity markets today is whether value’s recent outperformance is simply a (slightly prolonged) flash in the pan, or if a genuine regime shift is bringing a return to a heyday for cheap stocks.
Guessing whether value or growth will outperform next quarter has proven to be a fool’s errand. However, one guide that does offer strong powers of prediction for long-term performance between the two is relative valuations.
The reason? The relative valuation between growth and value tends to mean revert over time. In other words, very few expensive companies continue to get increasingly more expensive, and very few cheap companies go on to get cheaper forever. We see this relationship in the chart below, which shows the relative valuation between growth and value for the MSCI World.
Value’s median discount to growth has been 42% since 1975. You can see that whenever the discount moves significantly above or below this level (the dotted green line), mean reversion kicks in to bring it back to this long run median.
Despite value’s recent strong run of performance, it still trades at a c.60% discount to growth and far below the long-term median. Whichever region you pick, the story is the same; in the UK, Europe, emerging markets or globally, value stocks are still “on sale”.
As we can see from the chart, there’s only one precedent for today’s level of valuation dispersion: the post dotcom era. Of course, past performance is not a guarantee of future returns, but when the discount closed following the bursting of the dotcom bubble, value saw its most successful period on record. Proponents of the value style will hope mean reversion will continue to offer a powerful tailwind for its continued outperformance.
Of course, this argument is built on relative valuations. While the low relative valuations and the potential relative outperformance is welcomed, it is absolute performance that ultimately grows capital.
In that regard, despite value’s strong performance, its absolute valuation is still compelling, with the cheapest quintile of the global equity market trading on a cyclically-adjusted price-to-earnings ratio of 9.2x compared to long-term average of 13.0x. (The cyclically-adjusted price to earnings - or CAPE - multiple compares price with average earnings over the past 10 years, with those profits adjusted for inflation). History shows that low absolute valuations are attractive for long-term prospective returns.
Some people believe that value may struggle to maintain its recent better performance because of the likelihood of a recession. Recessions tend to hit cyclical companies - those most sensitive to the economic cycle - the hardest, and many cyclicals are value stocks given the volatility of their earnings.
The idea that as we move into a recession, earnings for these businesses will fall, perhaps dramatically, is not controversial. However, the stock market typically moves ahead of earnings downgrades when it values businesses, and even more so when a recession is well signalled, as is the case today.
In other words, you have to be prepared to buy ahead of the earnings downgrade cycle being complete. Wait too long, and the market already sees through the other side of a recession. By then the valuation has already moved and you have missed out on the bulk of the return.
This is why it’s important to have a long enough time horizon to hold businesses through the tough times brought by a recession. Just as important is being judicious about which economically-sensitive businesses you choose to own. We spend a lot of time scrutinising debt levels and stress testing financial accounts to see what it would take to break the valuation. The more room to manoeuvre the better, providing a crucial margin of safety.
While cyclical companies trading on trough valuations have a lot of bad news already baked in, the investor still has to be prepared to look naive until the tide turns. History shows trying to time the exact point at which that turning point may come is a virtually impossible task. In the eyes of the die-hard value investor, it’s better to be early than late.
Moreover, the assumption that owing value in a market sell-off or going into a recession is a bad idea is based on experience from the recent period of quantitative easing and ultra-low interest rates. It is not reflected in the longer-term data (nor in 2022). Prior to the financial crisis in 2008, and particularly given the strong outperformance during the dotcom bust, value was considered by many to be defensive. Value stocks proved defensive in the 1970s and 2000s in the aftermath of the Nifty Fifty and dotcom growth bubbles, as well as during periods of higher inflation, as they have also proved to be in again in 2022.
When bubbles burst, owning undervalued businesses - that is, the ones that did not become egregiously overvalued - tends to be a good idea. This was the case after the dotcom bubble, when growth did not outperform value for seven years.
It’s true that both the financials and energy sectors were key drivers of value’s strong outperformance in 2022. However, their contribution to the total outperformance of value in 2022 is perhaps less than many would assume.
Of the MSCI World Value index’s 23% outperformance over MSCI World Growth, 3.9% came from financials and 3.5% came from energy, leaving the remaining 16% from a spread across all other GICS sectors, with the exception of real estate. Versus the MSCI World, the value indices’ best sectors were information technology, followed by communication services and consumer discretionary.
As of today, there are a number of compelling opportunities around the global equity market on cheap valuations outside banks and energy. US technology has seen share prices fall, not only among the mega-cap tech businesses that have been grabbing headlines but also supporting products and services such as those in the memory space. China as a whole has clearly seen a significant sell-off. Elsewhere, communication services remain attractively valued as well as a number of European cyclical businesses such as German industrials or UK house builders that are on depressed multiples.
So while energy and financials – especially European banks – continue to be part of the value opportunity set, value isn’t a one-way bet on these sectors, and sensible sector diversification can be achieved while maintaining valuation discipline.