The difference in performance between the most expensive and cheapest stocks reflects a rotation from growth to value.
Historically, moderate and high inflationary environments have favored value stocks relative to growth.
We see opportunities in health care and tech, sectors outside of what investors normally consider “value” stocks.
As inflation moderates and the Federal Reserve (Fed) is expected to cut interest rates in 2024, the “COVID-19 era” in the economy and markets appears to be concluding. Plus, with the decreasing chances of a severe recession, markets are broadening from the very narrow market rally in 2023 fueled by the strong performance of the handful of US mega caps — the so-called “Magnificent Seven.” Investors are now looking to reallocate cash-heavy portfolios and rebalance their equity exposure. We believe it may be time to take a look at US value stocks. Here are four reasons to consider them now.
Value began to outperform in September 2020 after nearly a decade of underperformance compared to growth stocks. Comparing the period leading up to September 2020 with the period immediately following reveals a stark contrast. (See chart below.) The difference in performance between the most expensive (highest price/earnings) and cheapest (lowest price/earnings) stocks reflects a strong rotation to value, specifically from 2020 to the end of 2022.
Average return of price to earnings (P/E) quintiles
Source: Invesco, 12/31/2023. The price-to-earnings ratio (P/E) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS). Past performance does not guarantee future results. An investment cannot be made directly into an index.
The stock market has been on a wild ride during the past two years. In 2022, the S&P 500 Index stumbled, returning -18.1%, but rebounded significantly in 2023, delivering a +26.3% return. During the 2023 surge, the number of stocks outperforming the S&P 500 was unusually narrow and dominated by tech companies. Only 28% of stocks in the Index outperformed it last year, a historically low number.2 We don’t think this is sustainable.
Fast forward to February 2024. Consumer discretionary and industrials were the top-performing sectors, with many stocks within them hitting record highs. Restaurants, homebuilders, and travel stocks in the consumer discretionary sector contributed to the record highs. The industrials sector hit an all-time high, with nearly half of the stocks in it posting returns of more than 7%.3
Improving fundamentals and performance in various sectors and industries, combined with a favorable macro environment, may suggest broader performance this year — which could improve the odds for active fund managers. With a larger variety of stocks currently driving market returns, it’s no longer “a rising tide lifts all boats” scenario, which investors experienced in 2023 when investing in indexes like the S&P 500.
Some recent inflation-related data has spooked markets, but the reality is that inflation remains well under control. While no one can predict the future with certainty, historically moderate and high inflationary environments have favored value stocks relative to growth. Given the current moderate inflation rate, we believe there’s reason to expect continued value leadership.
Return difference between value and growth stocks in low, moderate, and high inflationary periods
Sources: Kenneth R. French at mba.tuck.dartmouth.edu/pages/faculty/ken.french/ as of December 31, 2022. Performance information is not the performance of an investment fund. Historical performance is not necessarily indicative of future performance. The graph above plots the trailing five-year monthly average annualized return of the top 20th percentile of the most expensive stocks (growth) versus the bottom 20th percentile of the least expensive stocks (value) within the largest 1,000 US stocks. Inflation source: Bloomberg, L.P. Inflation is defined as the US Consumer Price Index (CPI). Performance and CPI data from January 1, 1975 to December 31, 2023. Past performance does not guarantee future results. An investment cannot be made directly into an index.
Over the past few years since the COVID-19 market downturn, firms have implemented major expense reductions to preserve cash. Even when inflation was high and recession risks were rising, consumer demand remained strong, and many companies have seen a rebound in sales. We believe stronger revenues and lower fixed costs may lead to higher cash flows for undervalued businesses.
We take a highly contrarian approach — seeking companies others are ignoring. Our value investing philosophy is to seek companies with stock prices significantly below the intrinsic value of their underlying assets before the market spots the opportunity. Comparing a stock’s current trading prices to the true, intrinsic worth of the underlying company based on an objective financial measure, such as discounted cash flow analysis, helps determine if it’s under or overvalued.
Source: Invesco, 1/31/23. The price-to-earnings ratio (P/E) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS).
Source: Bloomberg, L.P., S&P 500 as of 12/31/23. The S&P 500® Index is a market-capitalization-weighted index of the 500 largest domestic US stocks. An investment cannot be made directly in an index. Past performance is no guarantee of future results.
Source: Yahoo Finance, industrial sector constituents represented in the S&P 500 Index as of 2/29/24.
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This does not constitute a recommendation of any investment strategy or product for a particular investor.
Investors should consult a financial professional before making any investment decisions. This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss.
Past performance does not guarantee future results.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Investments focused in a particular sector, such as consumer discretionary and industrials, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
The investment techniques and risk analysis used by the Fund's portfolio managers may not produce the desired results.
The S&P 500® Index is an unmanaged index considered representative of the US stock market. Investments cannot be made directly in an index.
The price-to-earnings (P/E) ratio measures a stock’s valuation by dividing its share price by its earnings per share.
Discounted cash flow (DCF) refers to a valuation method that estimates the value of an investment using its expected future cash flows.
The opinions referenced above are those of the author as of March 5, 2024. These comments should not be construed as recommendations, but as an illustration of broader themes.
Forward-looking statements are not guarantees of future results. They involve risks, uncertainties, and assumptions; there can be no assurance that actual results will not differ materially from expectations.
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