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.