Boston - Our research shows that value equity indexes — with their heavy weighting of cyclically sensitive sectors such as finance, energy and basic materials — tend to outperform during expansionary, reflationary economic periods. Today, the implied yield curve may well be signaling the start of another U.S. economic expansion — a positive portent for value equities. We believe that adding some value equity as a diversification1 hedge against other more correlated assets will ultimately prove to be a path to building better outcomes.
Stars potentially aligning for value equity...
While our Opportunistic Value investing approach focuses on individual stock picking, the U.S. macroeconomic backdrop is setting up to favor value equities, broadly. Our research shows that value equity indexes — with their heavy weighting of cyclically sensitive sectors such as finance, energy and basic materials — tend to outperform during expansionary, reflationary economic periods. These periods of outperformance, exemplified by accelerating profit growth, can often last many years and are often preceded by severe economic contractions such as the one we just experienced (see outperformance of Russell 1000 Value from 1981 to 1986, 1992 to 1993, 2000 to 2006).2
One common feature marking the onset of past U.S. economic expansions has been a steepening of the U.S. yield curve (Display 1). Typically, as the U.S. begins to recover, monetary authorities remain accommodative on the short end, while longer-term nominal rates (including their embedded inflation premium) tend to remain more elevated — steepening the curve. As shown below, the implied yield curve today may be signaling the start of another U.S. economic expansion — a positive portent for value equities.
... If investors are willing to seize the opportunity
Studies show an unprecedented level of correlation in recent times between narrow growth areas of the equity market and long-duration bonds. Further, these asset classes have outperformed more cyclical portions of the equity market for five years running — putting value stocks at a record-wide valuation discount to growth stocks. Many equity market participants have capitalized on these trends, to their benefit, while the broader market has become increasingly narrow.
Investors, by human nature, are keen to stick with their current paths, even when risks suggest potentially better expected outcomes elsewhere — a phenomenon that behavioral theorists call status quo bias. Adding some value equity to portfolios as a diversification hedge against other more correlated assets may be an easier first step for some, but we believe it will ultimately be the path to building better outcomes for investors.
Finding opportunity in today's fast-changing markets
The continuously changing nature of the COVID-19 pandemic has embedded itself into the perceived outlook and performance of more cyclical equities relative to large-cap growth leaders. The short-term volatility experienced in this environment creates excellent values for astute longer-term investors looking to help mitigate risk in their portfolios. Our Opportunistic Value approach is intentionally designed to take advantage of these environments by building concentrated exposure in a portfolio of companies that we believe will generate alpha for clients through the cycle.
Our team believes there is more at stake in the current environment than simply a short-term normalization of the economy. Interest rates have been on a multi-decade downward trajectory owing to globalization and a technology-fueled productivity boom. Although these trends should continue, the pace is likely to slow prospectively. Competition for a more mobile — and virtual — workforce is heating up labor rates. Large low-cost labor forces are disappearing globally with modernization in countries such as China. The reshoring of U.S. supply chains is also very likely to have a lasting impact, alongside a near decade of underinvestment in the world's natural resource stock.
The key point is that the status quo bias inherently ignores the potential generational shift of future inflation, the drivers behind it and the wide-reaching impacts of higher interest rates across the yield curve. We believe this creates ample opportunity for alpha generation.
Bottom line: Our philosophy targets strategically advantaged companies with high investment returns and strong cash flow generation. We look to invest in the stocks of these companies when they are out of favor or misunderstood by the broader market and, therefore, trading at a discount to intrinsic value — an approach we refer to as Opportunistic Value investing. We leverage our dedicated team of equity analysts, with an average of over two decades of experience, to find these opportunistic values. When we do find them, we invest with conviction, and we use a series of team disciplines to fight complacency and remain on an opportunistic footing for our investors.
- Diversification does not eliminate the risk of future loss.
- The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.
Russell 1000® Value Index is an index that measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.