Value stocks leading the market; can it last?
INSIGHT ARTICLE |
Until late last year, U.S. Growth equities had steadily outperformed their value counterparts for most of the prior decade. However, a strong rebound in economic growth — boosted by massive fiscal and monetary stimulus — has led to significant outperformance for Value stocks year to date. What led to this change in leadership, and will this trend continue?
Looking first at the characteristics that typically define and differentiate Growth and Value stocks can help investors better understand which economic environments tend to benefit one group over the other. When looking at the breakdown of the S&P 500 Index among the 11 GICS sectors (Figure 2), there is a lot of overlap within and among them, and each group contains stocks from all sectors. However, certain sectors are more heavily weighted towards one group or the other, and stocks within a particular sector that fit into a Value index versus Growth exhibit characteristics that are significantly differentiated.
Value stocks are generally characterized by relatively low valuation ratios (price/earnings, price/book, etc.), higher dividend yields, and are often issued by firms that operate businesses whose revenues (and earnings) are more exposed to the ebbs and flows of the economic cycle or are in more mature industries that provide few outsized growth opportunities. Stocks in the financials sector, the most heavily weighted in the S&P 500 Value Index, exhibit many of these characteristics. Growth stocks, meanwhile, tend to command higher valuation multiples, frequently pay lower or no dividends, and generate earnings and revenues that are less cyclical in nature. Companies in the technology sector, the largest in the S&P 500 Growth Index, have historically displayed above-average earnings growth, which contributes to their premium valuation metrics, while a need to reinvest all earnings back into the growing businesses often precludes the payout of a dividend.
As Figure 2 also illustrates (upper right), the S&P 500 Growth Index is significantly more concentrated than its Value counterpart and is heavily skewed toward the technology sector, which has been dominated by a handful of names (think Facebook, Amazon, Netflix, Google [FANG]) over the past decade. The S&P 500 Value Index, on the other hand, is comprised not only of a more diversified group of sectors, but those sectors tend to outperform at different stages of the economic cycle.
Cyclical versus defensive value: Where we are in the economic cycle matters
While Growth stocks are generally less beholden to the economic cycle, the fortunes of companies that operate in more cyclical industries — those more closely associated with Value stocks — tend to fare best in particular stages of an economic expansion. In fact, though stocks in value-oriented sectors share many characteristics, we can further divide the group into cyclical Value and defensive Value. This distinction is important because one subset tends to outperform during the earlier stages of economic cycles while the other outperforms in the latter stages.
There are myriad ways to gauge the state of the economy. Among the more common measures are: gross domestic product1 (GDP), Purchasing Managers Indexes2 (PMI), interest rate levels, employment levels, and inflation.
During the earlier stages — an environment often characterized by accelerating GDP growth, PMI readings moving from contractionary (below 50) to expansionary (above 50), low but increasing interest rates, a strengthening job market, and low but modestly increasing inflation — one would expect cyclical Value stocks to fare better. These conditions are conducive to rising consumer demand, which spurs business demand for production inputs (materials) and loans (financials) for inventory build-up and company expansion, all of which have a trickle-down effect to businesses across the industrials and energy sectors, among others.
In the latter phases of the cycle, GDP growth is decelerating or contracting, PMI readings are falling, interest rates are relatively high and poised to fall, and employment is at or near peak levels. Optimism turns to caution, and investors look to companies with stable, predictable earnings, which correlates with stable, predictable consumer demand. This environment favors defensive Value sectors such as consumer staples, utilities, and healthcare.
The last 18 months provide an excellent illustration of investor demand for both defensive and cyclical Value in different economic environments. The charts below separate the cyclical and defensive sectors from the S&P 500 Value Index. The first half of 2020, which includes the major market selloff, saw defensive Value sectors hold up significantly better than cyclical Value as GDP growth plummeted amid the pandemic-induced lockdown, inflation and interest rates fell precipitously, and PMI readings fell swiftly into contractionary territory. Then, as the economy rebounded and economic data trends reversed, cyclical Value sectors significantly outperformed.
Can (cyclical) value continue to outperform?
With broad Value outperforming Growth year to date to the tune of roughly 7%, and cyclical Value outperforming defensive Value by more than 17% over the same period, investors may question the sustainability of such outperformance. Looking at some of the data helps to construct a more informed view.
Despite Value’s historically lower valuation multiples, as well as its recent outperformance, P/E multiples based on forward earnings imply Value stocks remain cheap relative to Growth (Figure 4). Data for price/book, price/cash flow, and price/sales paint similar pictures.
Looking ahead near term, FactSet data show S&P 500 Index earnings estimates for the second quarter are projected to grow more than 40% compared to the same period a year ago, underpinned by a sharp increase in profits from firms in cyclical sectors such as: industrials, materials, and financials. For the full year, index-level earnings are expected to rise 35% with Value stocks continuing to lead.
We believe the economic recovery has begun in earnist. Pent-up demand that is emerging in some of the hardest hit industries (i.e. travel and leisure), coupled with the likelihood of additional fiscal stimulus, suggests growth will continue to be robust over the next 18-24 months or longer. Sustained above-average growth should support continued strength for Value stocks. Further, despite the group’s outperformance since late last year, valuations relative to Growth remain below long-term averages. However, the economic recovery remains fragile, and the relatively more attractive environment for Value stocks does not mean Growth equities should be abandoned. We continue to recommend a balanced approach among the two groups, but suggest those looking for a portfolio tilt consider leaning towards Value.
1 Total value of goods and services produced in a country during a year
2 An closely followed indicator of services and manufacturing activity
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