March 2023 / U.S. EQUITIES
Why Value Stocks Are Becoming More Competitive Again
The investment environment has undergone a decisive shift.
After a decade of dominance by growth stocks, value stocks came back with a vengeance last year: The MSCI World Value Index outperformed its growth counterpart by more than 20 percentage points. This does not necessarily mean that value investing is set to dominate growth for the next decade, but it supports my view that the headwinds facing value stocks are easing and that, at the very least, value is set to become more competitive than at any time since the global financial crisis (GFC).
Why did growth stocks dominate for so long? Partly because, following the GFC, there was a long period of low interest rates, which have tended to favor growth stocks that promise stronger cash flows in the distant future. Bond math suggests that lower interest rates cause longer‑dated cash flows to have higher present values. Value stocks are not helped as much by lower interest rates because value firms are typically expected to generate profits over a shorter time horizon.
While interest rates have been a factor, we believe the main reason for the dominance of growth stocks is that disruptive technology, including online shopping and digital marketing, really delivered for investors. The market was slow to understand the potential of many of these stocks, which then substantially exceeded expectations. As the potential of some of the new technology became clear, investors piled in, fueling a boom period for growth stocks.
I believe the period ahead will be different. For one thing, a return to very low interest rates is very unlikely in the foreseeable future. While inflation will likely come down from current levels, the onshoring and “near shoring” of supply chains means we may be heading into a new epoch in which inflation remains elevated for an extended period as deglobalization makes it more difficult for companies to reduce labor and raw material costs. If that happens, rates, too, will remain high compared with recent history. In higher rate environments, current earnings tend to become more valuable and future earnings less valuable, which favors value stocks.
In addition, while the era of technological disruption is not over, we believe we have entered a more mature phase in this process. We are circumspect about our ability to predict the future, but we think it likely that in 10 years’ time people will still be streaming videos, shopping on the internet, and driving more electric vehicles. However, these industries are likely to become more competitive. Early innovators may not be the best long‑term investments from here: Netflix and Tesla, for example, will both face stiff competition as other companies innovate and catch up. Over the next 10 years, the most attractive investments may be in older incumbents that have been hit hard by disruption but can also leverage the new technology and effectively compete in the new categories. For example, if Volkswagen, which currently has an extremely low valuation, ultimately produces electric vehicles that are competitive with the high standard set by Tesla, expectations for both companies may be wrong.
The Investment Environment Is Changing
(Fig. 1) Valuations will matter more in the period ahead
|What’s Changing||Possible Features of the Next Decade|
Interest Rates and Inflation Likely to Be Higher
Innovation Better Understood
Value Has Done Well in Wake of Speculative Excess
Equity Has to Compete With Other Asset Classes
Value Investing Is More Competitive
Dividends Matter More
In the past, value has performed well following periods of speculative excess (for example the “Nifty‑Fifty” and “dot‑com” eras) as high embedded expectations turned out not to match actual fundamentals. If the current period of speculative excess comes to an end as the era of disruptive technology matures, value companies may benefit once again.
Combined, I believe that an extended period of higher interest rates and the maturing of the recent period of disruptive technology may establish a better environment for value stocks. This is not to suggest that value will dominate the next 10 years in the way that growth has dominated the past 10, but it does mean that value investing is likely to play a more important role in investor portfolios as higher rates create broader earnings growth and investors focus more on cash flows.
Value Is a Key Component of Portfolio Construction
(Fig. 2) Portfolios need both growth and value stocks
|Russell 1000 Value||11.58%||14.94%||0.49|
|Russell 1000 Growth||11.35%||17.30%||0.41|
Although expectations and valuations for growth stocks have fallen to a degree, they remain elevated compared with value stocks. With higher expectations, the downside risk associated with disappointment in the trajectory of company fundamentals is considerable; conversely, there is a relatively lower expectation of value stocks.
I will explore these ideas in more depth in further blogs over the coming months. For now, it is worth reiterating my view that the current investment climate for value stocks is as favorable now as at any time since the GFC.
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