Are we really witnessing the prolonged rally that every value investor has been dreaming about for the past decade?
The truth is that the value rally has evolved significantly for more than 18 months – amid numerous bouts of volatility. Even after the initial large rotation into value in November 2020, we immediately saw a period where the trends reversed, as a secondary wave of Covid infections hit the potential economic re-opening.
The markets would tell us value has re-asserted itself in the first half of this year. In January 2022, we saw the biggest rotation globally in value in the past 50 years, while a growth driven sector like technology suffered its second worst quarter in two decades.
Two significant events stand out for this move.
The first is the quick death of the idea that inflation is transitory (in the UK and the US inflation now stands at 9.4% and 9.1% respectively). Even if those figures halved in 12-18 months, inflation would still be operating at a fundamentally different level to what we’ve seen since 2009 – this is very much a new economic cycle.
We’ve also had the outbreak of war in Europe. Prices were high before Russia’s invasion of Ukraine, which has further disrupted energy markets and food exports, forcing developing countries to pay more.
Value has outperformed growth on a global basis – but there’s a catch
On a global level, value has comfortably outperformed growth in 2022 – although it should be pointed out both are loss making, with the MSCI Global Value index down 11.4% versus 23.4% for the growth index.
Strip back the numbers and what you find is that this is very much an energy fuelled value rally – as rising prices have seen the sector return 28% year-to-date. Contrast this to other popular value sectors likes financials and materials, which are down 5% and 9% respectively.
You can view this two ways.
The pessimist in me would point to the fact that value companies are cyclical and heavily exposed to the global economy. With recession an increasing likelihood these tend to be the companies that get sold off most aggressively. Energy is the outlier on this occasion, due to both inflation and the imbalance between supply and demand in this sector.
The counter to this is there is scope for valuations to become even more attractive in recession (although some of this is likely to have already been priced in).
GMO believes value still represents a significant opportunity. Based on its own ‘Price to Fair Value’ valuation metric, which calculates the ratio of the most expensive fifth of stocks divided by the cheapest fifth of stocks within each country/region, showing where we are today compared to the median value (and an indication of the range of values) through history. It found that the ratio of Price to Fair Value for cheap stocks relative to expensive stocks sits at the 9th percentile since 1990 – indicating that there is a tremendous amount of scope for cheap to outperform expensive in order to return to a normal valuation differential.
History tells us there is still significant upside to be made through value investing. There is a chance that a recession could make these sectors even cheaper, but it’s never sensible to try and time these things, particularly when they already look so attractive versus their own history. What we do know for certain is we are in a new cycle where the tug of war between growth and value is likely to be much more keenly fought than it has been in the past decade.
Here are few potential entrances to value:
In comparison to other developed markets and the US in particular, the UK market is still cheap - for example, it is currently trading around 10 times 2023 forward earnings versus the US which is on 16 times. Amid a more challenging global outlook, the UK market also remains relatively well placed, mainly due to its sector exposure (the FTSE 100 has a strong value tilt) and the low valuation starting point.
If global markets and the diversification they bring are more your bag, I’d look to the Schroder Global Recovery team of Nick Kirrage, Andrew Lyddon and Simon Adler. Built on the success of their UK franchise, this portfolio typically holds approximately 50 names from different parts of the globe, depending on where the managers are seeing the best investment opportunities.
Another alternative is GQG Partners Emerging Markets Equity run by Rajiv Jain. His emphasis is on future quality, rather than companies which have simply done well historically, and a stock is only purchased when it is trading at a significant discount to his intrinsic value estimate.
And let’s not forget that dividends and dividend growth could become and even more important component of total returns going forward. Launched in October 2017, GAM UK Equity Income fund invests in companies of all sizes – from the very small and those listed on the AIM stock market, through to the FTSE 100. Manager Adrian Gosden believes dividends are the most important driver of total returns and while he is targeting a yield higher than that given by the UK stock market, he is also looking for steady dividend growth.
And of course, City of London investment trust is an option. Manager Job Curtis focuses on companies that can pay and increase their dividends over time. He pays close attention to valuations and is careful not to overpay when he initiates positions.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre. The views expressed above should not be taken as investment advice.