Boston - Value stocks are at an unprecedented valuation discount relative to growth stocks. We believe, despite some potential uncertainty ahead, there may be significant, generational opportunities for alpha1 creation for value investors in today's markets.
Time for value?
As we entered 2022, we noted that the U.S. macroeconomic backdrop was broadly tilted in favor of value equities. We could not have predicted, however, that the Russell 1000 Value Index would outperform the Russell 1000 Growth Index by the widest margin of any quarter in over a decade. With bonds also experiencing a historically large sell-off, bonds and growth equities continue to be tightly correlated.
Our research shows that value equity indexes like the Russell 1000 Value — with their heavy weighting of cyclically sensitive sectors such as finance, energy and basic materials — tend to outperform during economic expansions, including 1981-1986, 1992-1993 and 2000-2006 as seen below.
Rough waters ahead?
Looking ahead, we do not anticipate smooth sailing, as crosscurrents abound. Portions of the economy are still in the process of reopening — in many instances with significant pent-up demand — though there are still monetary policy, geopolitical demand and supply chain risks.
While cyclically oriented sectors tend to outperform during economic expansions, the performance challenge of these sectors over the past several years was less about anemic economic growth and, instead, driven more by the method in which economic growth was achieved. Federal Reserve monetary policy, both through the control of short-term interest rates and use of its balance sheet to control the longer end of the yield curve, produced structurally lower profitability for the financial sector.
Additionally, inflation is high, at rates not witnessed in 40 years, threatening corporate profit margins with rising input costs. Labor rates are increasing as competition for a more mobile — and virtual — workforce heats up, and offshore sources of low-cost labor disappear with modernization.
Russia's invasion of Ukraine has rattled markets and served to underscore global trends that were starting to take shape: Long-term underinvestment in critical commodities would eventually lead to tightening supply dynamics, while a new paradigm in inflation and interest rates would settle in for longer than expected.
Making the case for active management
Investors who feel unsettled in choppy markets may seek the psychological safety of consensus views. But the ability to navigate these crosscurrents effectively can lead to opportunities for alpha, which helps to make a compelling case for active equity portfolio management.
During times like these, we seek opportunities to invest in strategically advantaged companies with the potential for high financial returns and strong cash flow generation. Just as important, we look to invest in companies that are out of favor or misunderstood by the broader market — and trading at a discount to their intrinsic value.
Bottom line: Inflation, interest rates, global supply chains, labor costs, the Russia/Ukraine war and a technology-fueled productivity boom are having a wide-reaching impact on the global economy. The world is changing, yes, but we think many of these once-in-a-generation trends could favor value investing.
- Alpha is the excess return or value added (positive or negative) of the portfolio's return relative to the return of the benchmark.
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.