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Is value investing dead? It’s a provocative question that I’ve had to answer a lot in recent years, and a fair one in light of market performance patterns over the past decade-plus. Excluding value stocks’ stunning post-pandemic rebound, growth-style equities have more or less reigned supreme since the global financial crisis (GFC) of 2008 – 2009, as the search for fast-growing companies relative to lackluster economic growth became a guiding principle for many equity investors.
Can we be confident that the next decade of equity investing will look the same? I don’t think so. In fact, I believe the drivers of the next economic cycle could well favor value stocks over their growth counterparts.
To illustrate, I put my thesis to the test against some questions clients have been asking me lately:
1. Doesn’t equity performance depend on the prevailing economic cycle?
Conventional wisdom says yes, but our research shows this is only true to some extent. Historically, the periods in which value stocks have outperformed before giving way to growth leadership have lasted anywhere from 10 to 20 years and don’t always line up neatly with economic recessions. As Figure 1 shows, value sometimes outperforms growth coming out of a recession, but not without fail. I think a more accurate guide to equity style performance can be found in a set of four factors — inflation, real interest rates, liquidity, and GDP — that seem to better align with value cycles, and which show that we are still in the early stages of the value cycle that began in 2020.
2. Isn’t value overly dominated by financials and energy?
This is another commonly held assumption that doesn’t hold up to scrutiny. In reality, the sector compositions of the Russell 1000 style indices have shifted markedly over time, resulting in value now being much more diversified than in the past. Currently, the growth camp is highly concentrated in technology (40%), followed by energy and consumer discretionary (15% each). Value, meanwhile, has its largest sector weightings allocated to health care (18%) and financials (17%), followed by industrials, technology, and telecommunications (10% each). So, among other things, this greater sector diversification means the value index is now better positioned to weather a sudden, sharp downturn in any one sector.
3. Value stocks have been cheap for quite a while, so what’s different now?
Despite value’s strong performance in 2021 and 2022, broadly speaking, these stocks remain inexpensive on a simple price/earnings basis. What has changed is profitability in the value space. I look at a profitability metric — free cash flow relative to enterprise value — to assess how efficiently companies are generating cash vis-à-vis their total market value. For most of the post-GFC era, growth has had a higher such ratio than value but that flipped in 2020, rendering value more attractive from that perspective. Just remember that valuations alone are typically not a primary catalyst for outperformance by value, but they can provide support if other positive drivers are in place, particularly higher inflation and interest rates and the ongoing transition to green energy (see below).
4. So, how exactly would higher or “stickier” inflation change your bullish outlook for value?
If anything, it would boost my conviction in my outlook because value has historically delivered some of its strongest performance runs during higher-inflation periods, punctuated by the “hyperinflation” stretch the US experienced in the 1970s and 1980s. While I don’t expect today’s inflation to approach those lofty levels, I do think several macro forces will likely conspire to keep consumer prices elevated over at least the next few years. Ongoing labor and commodity shortages, post-COVID supply chain rejiggering, the broad trend toward deglobalization, and that inexorable energy transition noted above are all elements of what could be a new higher-inflation, higher-interest-rate regime.
5. What could go wrong that might undermine your thesis?
A scenario in which the US Federal Reserve (Fed) rapidly cuts interest rates, while unlikely as of this writing, could propel growth over value, given the former’s inherently longer duration. However, while an economic recession would seem like a big risk, value actually outperformed growth during the US recessions of 1960, 1973, 1990, and 2001. If I’m right though, higher-for-longer inflation and rates should assert themselves as key engines of value stock outperformance in the period ahead.
The value/growth debate is much more nuanced than the facile rules of thumb that investors frequently apply. I believe investors should consider that we may be in a new investment landscape characterized by higher inflation and rates, plus more investment and spending targeted toward enabling the energy transition. At the very least, with growth indices becoming more concentrated in mega-cap technology stocks, I believe many investors should seek to improve overall portfolio diversification with increased allocations to value.
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