Macro Research

Value stocks are back in favour. Time to add Value exposure.

Value is again in the spotlight after the year-to-date solid performance. Here's why we continue to see rotation opportunities and why investors should increase exposure to Value.

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  • Published on 19 Apr 2022

Value stocks are back in favour. Time to add Value exposure. | Open a FREE FSMOne account and manage all your investments conveniently in ONE place

  • Value remains supported by the inflation backdrop. On the basis of elevated price pressure and upside risk to inflation, Value can outperform growth. The former tends to outperform i) during periods of high inflation and ii) rising policy rates.
  • Despite moderation in global growth momentum, we see growth catalysts down the road, mainly from fiscal impulse and Asia’s re-opening. The reopening wave should also put Value in the spotlight again.
  • Relative valuation remains attractive. Value continues to trade at a wide discount to Growth. At such an extreme level, there is room for the value rotation to run and for the discount gap to close. Earnings momentum supports further Value rotation.
  • Considering our view on Value and Growth, we recommend investors to review their portfolio exposure. If their portfolios are skewed towards Growth, especially the unprofitable and over-valued stocks, they should diversify away and add Value exposure.

Value and Growth are two fundamental styles of equity investing. Value stocks represent companies that possess good fundamentals but might be under-priced as valuations may be lesser than historical average or industry peers. Value indices often screen for stocks with Value characteristics using a mix of valuation metrics, such as book value to price, 12-month forward earnings to price, and dividend yield.

On the other hand, Growth stocks represent companies that are expected to deliver high levels of earnings growth in the future. These companies may or may not be profitable now but typically possess strong revenue growth. Growth indices often screen for stocks with Growth characteristics using a mix of profitability metrics, such as long-term forward EPS growth rate, long-term historical EPS growth trend, and long-term historical sales per share growth trend.

The growth versus value debate has again resurfaced since the start of 2022. The escalating global inflation concern has fuelled a fierce rotation back to Value, as Growth was hit by the prospect of increasing rate hikes. In the year to date, Value indices have outperformed Growth indices (Chart 1), with Japan and China Value indices demonstrating the strongest outperformance. Despite the solid performance, we continue to see rotation opportunities in Value and ongoing headwinds for Growth. In this article, we outline the reasons why and strategies to increase exposure to Value while diversifying away from Growth. 

Chart 1:  Value vs Growth performances for global indices since 2021



The Value composition


The Value factor has always shared an intimate relationship with inflation and economic growth. For decades, the Value composition has overweighted sectors such as financials, industrials, and energy (Chart 2). These are inflation-sensitive and cyclical sectors that are highly levered to economic growth. As a result of these exposures, Value indices typically excel during periods of rising economic growth and inflation, leading to outperformance against its Growth counterpart. 

As seen from Chart 3, sustained periods when Value outperformed Growth were in 2Q87 – 3Q88, 4Q91 – 2Q94, and 1Q00 – 1Q07. These were periods when the above macro dynamics were notably present. Furthermore, earnings growth for cyclical sectors – which have major exposure in Value indices – were often bolstered by the macro backdrop of rising growth and inflation, which in turn supported Value performance as well.

Chart 2: The Value composition primarily overweight inflation-sensitive, cyclical sectors


Chart 3: Periods when Value outperformed Growth

 

Inflation, the dominant driver for Value


Inflation is often the by-product of an economy that is growing above potential. However, in this cycle, it has been supercharged by factors such as a monetary-induced demand, supply-chain disruption, and mounting commodity prices. This has resulted in multi-decade high inflation readings across major economies that have fuelled Value performance over the past few quarters. Moving ahead, we expect inflation to remain the dominant driver of Value performance given the latter’s tendency to outperform Growth i) during periods of high inflation and ii) rising policy rates. 

Historically, the performance of Value relative to Growth has exhibited a strong positive correlation to inflation expectations (measured by the US 5Y5Y forward inflation swap rate). With global inflation levels above the long-term average before the Russia-Ukraine war, the recent spike in commodity prices should extend the inflationary pressure which is already pressured by higher input prices and labour costs. The longer this persists, the greater the upside risk to inflation. As such, the likelihood of elevated inflation readings is high this year and could support Value performance (Chart 4).

Additionally, empirical data has shown that Value tends to outperform Growth when policy rates increase (Chart 5), especially in the initial phase of a rate hike cycle. This stems from Value stocks having a shorter duration (more cash flow are upfront) as compared to Growth stocks, which have a longer duration (larger cash flow in the future, many companies are even unprofitable in the near-term). This dynamic should also anchor Value performance moving ahead, considering the Fed rate hike cycle has only just begun.

Chart 4: Value performance should remain supported given elevated inflation expectation, even after base effects fade

 

Chart 5: Value tends to outperform during Fed rate hike cycles, especially early in the cycle



Macro backdrop remains challenging for Growth


On the contrary, the prevailing macro backdrop continues to prove challenging for Growth. As outlined above, stubbornly elevated inflation levels and the presence of upside risk will likely fortify policymakers’ decision to tighten aggressively, as witnessed in the recent Fed meeting. This raises the likelihood of larger and more rate hikes, as well as a faster pace of balance sheet reduction, all of which may continue to pressure valuations of Growth-style equities.

That said, we believe this headwind will have an uneven impact. Growth stocks that are non-profitable, smaller in market cap, and with high valuations remain most at risk. As seen from recent sell-offs, non-profitable tech, meme stocks, and SPACs have all had significant drawdowns. However, growth stocks that have demonstrated the ability to deliver quality earnings over time (i.e. Google, Apple, Meta, Amazon, and Microsoft) are holding on well. 

Global growth backdrop still supportive for Value


In our view, Value will continue to hold up well given the current economic growth backdrop. Recently, concerns have arisen regarding the growth outlook in 2022 due to the potential impact of the Russia-Ukraine war and the Fed rate hike cycle. While these factors will likely result in a moderation of global growth momentum, especially coming off a robust rebound last year, we expect the global recovery to carry on.

We see several catalysts down the road that could support global growth and in turn, remain conducive for Value performance. First, we see room for more fiscal support across major economies. Policymakers are already facing mounting pressure to reverse their fiscal tightening decisions and increase support amidst rising commodity prices. A current account surplus may embolden the decision to do so.

Second, and more importantly, we look to the potential re-opening wave in emerging markets (starting with Asia) from 2Q onwards, which is likely the most significant growth driver this year. The impacts are likely twofold, starting with an uplift in domestic demand in these economies, followed by a global growth boost generated by an influx of cross-border tourism.

The reopening should also continue to put Value in the spotlight. Drawing reference from the reopening of US and Europe, we believe investors’ focus will continue to shift towards re-opening stocks, companies that are highly leveraged to the economy and global activities. However, we believe they will increasingly be seeking undervalued re-opening stocks this time round, considering the greater margin of safety amidst the current risk backdrop. This will likely keep inflows to Value equities strong as many of these re-opening stocks are part of the Value composition.

Chart 6: Economic growth also has an intimate relationship with Value performance



Fundamentals support Value performance


Aside from the conducive macro setup, as outlined above, we note that underlying fundamentals for Value indices remain solid and continue to justify the rotation. Earnings momentum continues to swing in favour of Value as compared to Growth, given the former’s earnings sensitivity to growth and inflation. 

Value (gauged by the MSCI World Value index) has enjoyed consistently positive EPS revision since 2021 and a 4% upwards revision in the year-to-date. On the other hand, Growth (gauged by the MSCI World Growth index) has only seen a 1% positive revision to earnings estimates. As shown in Chart 7, the improving earnings fundamental of Value relative to Growth is also pivotal in supporting Value outperformance.

Chart 7: EPS momentum still in Value’s favour


 

Attractive relative valuation 


Value continues to trade at a wide discount to Growth. The MSCI World Value index is trading at a gapping 50% discount to its Growth counterpart, which is around two standard deviations below the historical average of 30% (discount). The relative valuation remains attractive in our view. At such an extreme level, we see further room for the value rotation to run and for the discount gap to close. 

While there has been recent improvement (Jan and Feb) in the relative valuation of Value against Growth, this has been largely driven by the sell-off in Growth rather than a rally in Value. Considering how the Value rally in 4Q21 was rather short-lived as compared to previous runs, another run is possible, especially with the current macro dynamics. 

The wide valuation discount is rather unanimous across global equity regions, such as US, Europe, and the EMs, implying that Value opportunities should be global. We, therefore, expect Value rotation to be a global dynamic, considering the drivers of global and inflation are on a global scale. As such, applying a value tilt on equity exposure is a viable strategy. 

Chart 7: Relative valuations show ample room for Value to re-rate higher

 

Time to review portfolio exposure – Strategies to consider


In sum, we continue to see rotation opportunities in Value and expect its performance to be firmly supported moving ahead. Any upside in inflation or macro growth data should drive the performance of Value, which is bolstered by attractive relative valuations and robust earnings momentum. 

While Value may appear attractive today, betting solely on a single style has its own risk, especially if fundamentals do not play out or if the macro backdrop takes a sudden shift. Moreover, there are merits to growth investing, as we recognise that technology, which dominates Growth, will continue to play an important role in the increasingly digitalised global economy.

Considering our view on Value and Growth, we recommend investors to hold a combination of value and growth stocks. They should also review their portfolio exposure – if their portfolios are skewed towards Growth, especially the unprofitable and over-valued stocks, they should diversify away and add Value exposure. This can be implemented on a geographical and sectoral level.

At the geographical level, we recommend trimming exposure to regions with a high concentration of Growth stocks by (i) reducing exposure to US equities and (ii) adopting a value tilt through Value-oriented funds like the JPMorgan Funds - US Value A (acc) USD and the HGIF - Europe Value PD SGD. We also recommend re-allocating the exposure to regions that have a Value slant, such as ASEAN and Singapore equities. We recommend the Principal ASEAN Dynamic Fund Class SGD and the Nikko AM Singapore Dividend Equity SGD.

At the sectoral level, we recommend trimming exposure to Growth-oriented sectors like IT, especially unprofitable and overvalued tech companies. We also recommend re-allocating the exposure to financials and commodity-related sectors which, as outlined in the above section, are key overweights of Value indices. We recommend the Blackrock World Financials A2 USDBlackrock World Energy Fund A2 USD, and the JPMorgan Funds - Global Natural Resources A (acc) USD.

Table 1: Recommended products 


The Research Team is part of iFAST Financial Pte Ltd.

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