The Value Of Value Is Still Compelling
Despite growth valuations falling by twice as much as value in 2022, the relative value of value remains well above historic averages.
Avalon_Studio by Sam Peters, CFA Still Early Stages of a Strong Value Cycle As Einstein has shown, everything is relative and events have impacts on each other. Each market cycle is different, and this is what makes investing so challenging. We do know that markets cycle between fear and hope, and that key events are more likely to occur in similar circumstances. We noticed the first major change: everything became cheaper when multiples were reduced. The absolute multiple of the Russell 1000 Growth Index, (RLG), decreased by just over 30% while that of the Russell 1000 Value Index, (RLV), dropped almost 15%. Despite the fact that growth valuations fell twice as fast as value, relative value of value remained high above historical averages and remained at the lowest decile (Exhibit 1). This is a key observation. The relative performance between value and growth styles has never stopped at these levels. It may be difficult to believe that there wasn't more growth, given how painful 2022 was for growth investors. While progress was made, it was not enough to eliminate investor excess. Exhibit 1. Value remains historically undervalued as of December 31, 2022. Source: Bloomberg Finance L.P. ClearBridge Analysis. Nearly 100% of the market's change in valuation multiple between 2022 and 2023 was due to the movement in interest rate. This left the equity risk premium flat. Surprisingly, fundamentals did not impact performance. RLV earnings grew by 5% and RLG earnings grew by 1%. Like volatility indices and high-yield spreads, valuation spreads tend to explode during recessions. The current valuation spreads are below average (Exhibit 3) and this is further evidence that markets do not price in fear. Stocks are historically not cheap and don't embed a recession in an absolute basis. Exhibit 3: Value Spreads Close to Historic Average as of December 31, 2022. If the Fed does indeed cause a recession, spreads on valuations will likely follow historical precedent and gap out. Spreads will rise with each occurrence of a recession. However, this list typically includes past winners who were forced to sell due to excessive leverage or worsening fundamentals. This will be true again, we believe. We see distress concentrated in stocks that were most benefited from the free capital era as well as excessive speculation by investors with leverage and derivatives. The tactical opportunity to profit comes when equity correlations rise during risk events. Good stocks are often thrown out with bad. We don't want to anchor expectations. Instead, we use our strict valuation discipline to navigate the chaos and find attractive stocks even when no one is looking. Sam Peters, CFA, is a Portfolio Manager. He co-manages both the Value Equity Strategy (and the All Cap Value Strategy). He has more than 30 years of experience in investment. In 1997, he was awarded the CFA designation.