The value investment style has faced material performance headwinds for a prolonged period, as evidenced in the long run of relative underperformance of value-style market indices, both domestically in Australia and globally. These headwinds had been driven by a combination of factors including benign global inflation rates, sub-trend economic growth, and historically low monetary policy settings. This has supported increasingly high valuations across certain segments of the market, particularly in technology and other growth style sectors.
We have been talking about the inevitable rebound in value performance for more than 12 months as economies recover from the COVID-19 downturn, and why investors should be positioned in quality Australian value stocks. As the economic reopening gathers momentum, as predicted, the tide has continued to turn in favour of value performance, and over recent months growth stocks have seen a severe price reversion.
Value’s relative performance has bottomed
Since 3Q 2021, we have seen a meaningful reversal of the relative performance between value and growth. While it is naturally extremely challenging to accurately call the bottom of a cycle, it appears that the performance tide has now turned, both locally and globally.
The shift in relative performance has correlated closely with strengthening momentum behind the reopening of global economies, as COVID-19 restrictions have been progressively eased and borders have begun to reopen. This has been associated with an acceleration of key inflation measures, as well as expectations for the normalisation of extremely loose monetary policy settings.
Growth P/E ratios not supported by earnings
It is interesting to note that the rate of EPS growth for value and growth style stocks had been relatively consistent over time. This highlights that the most recent divergence in performance for the two investment styles has been primarily driven by inflated prices being paid for growth stock exposures in recent years, rather than fund flows supporting more profitable companies. This has resulted in the significant expansion of P/E multiples for growth stocks.
Notably, we have seen another instance of this trend occur in the late 1990s with the dotcom bubble, which was associated with a rapid rise in technology stock valuations fuelled by widespread investment in internet-based companies. As the below chart shows, this led to a significant stretching of growth stock P/E multiples, which subsequently sharply de-rated when the bubble burst in the early 2000s, helping to spark a strong reversion in relative value performance.
Technology stocks are once again at the forefront of the current growth stock multiple expansion. While the sample set of these occurrences is obviously small, this does highlight the potential danger of investing in such a high-risk momentum play, as well as the upside for value should a normalisation subsequently occur.
Value rewarded at recent reporting season
During the recent February 2022 domestic reporting season, we saw quite meaningful broker EPS revisions across stocks trading on high valuation multiples – i.e., the typical growth style exposures. The notable P/E expansions had increased the level of ‘risk’ baked into these growth names and these revisions resulted in quite significant de-rates for growth stocks. This has exacerbated the severity of the performance unwind that we have seen playing out through the year-to-date. Conversely, stocks trading on lower multiples, typically value-style exposures such as commodities, energy, and financials stocks, saw more upward EPS revisions, and thus a more promising price reaction through reporting season.
Value spreads remain attractive despite uptick
Even accounting for the recent uptick in value performance, we see ongoing material upside for the value style. Our proprietary methodology shows that the fair value gap between the most attractive value-style stocks and the broader market, or what we call the ‘value Spread’, remains at a notably stretched level versus history. Despite the sharp reversion of relative performance, the spread remains the widest it has been since early 2012, highlighting that as the spread narrows, the return opportunity that our model estimates is still very significant. This further shows the extent the P/E expansion across growth style stocks have to unwind, and highlights the magnitude of the upside scenario that we see for value stocks looking forward.
Inflationary forces provide value tailwind
Following a prolonged period of challenged growth, exacerbated by strict COVID-19 restrictions, global economies have now begun to reopen in earnest. This has been associated with a material inflationary spike with Consumer Price Index (CPI) prints across major economies pushing to the strongest levels seen since the recovery from the GFC. While the inflationary spike itself has been significant, importantly beneath the headline strength we are also now seeing a reconfiguration of the underlying drivers of inflation.
A clear dynamic over the past decade has been that non-tradeables (services) inflation has been stronger than tradeables (goods) inflation. This strong demand for services had meant that many growth style companies were able to maintain quite healthy earnings while their input costs fell, supporting the outperformance over the typical value-style companies levered to tradeables inflation.
The recent inflationary spike that we have seen has reflected a swing back to tradeables inflation, with increasing goods and commodities prices helping to generate momentum behind the move. Increasing goods costs with relatively static input costs will help to create a beneficial environment for value stocks such as resources companies and other goods producers, strengthening the tailwind for value’s relative outperformance going forward.
Economic factors create solid value backdrop
Value stocks have historically shown a strong performance correlation with strengthening economic growth and movements in bond yields. These factors have clearly provided a headwind for value in recent years, with pandemic-induced lockdowns driving a global economic slowdown and inciting an extreme monetary policy response from central banks.
As restrictions continue to be eased, measures of global growth, such as the World Purchasing Managers Index (PMI), are reflecting a rapid economic recovery, driving a material spike in inflation and raising expectations of monetary policy tightening through 2022. We believe that these conditions will provide a supportive backdrop for the continued outperformance of value stocks going forward.
The sharpness of the recovery from COVID-19 lockdowns around the globe has seen a significant spike in the World PMI, without an equivalent narrowing of value spreads. This enduring gap further highlights the significant opportunity that value exposures represent as the global economy continues to reopen. value style stocks remain cheap relative to the broader market despite the period of outperformance through the year-to-date.
Rising yields have historically shown a strong correlation with positive value style returns and a narrowing of the value spread. Yields had been trending lower since the GFC as monetary policy settings were progressively loosened in an effort to spark growth. While central banks are naturally being quite cautious, monetary policy settings are beginning to normalise around the globe, and forecasts for major economies suggest that rates will continue to rise, which will push bond yields higher and should therefore provide a tailwind for relative value performance.
Australia presents a compelling value opportunity
Within this improving thematic for value, we believe that the Australian market is particularly well-placed to outperform in an improving economic environment, relative to the US or other global market equivalents. The Australian equity market is notably value-tilted, with a large weighting to very high-quality financials, which will benefit from rising interest rates, and materials/resources, which will benefit from supply chain limitations/disruptions and growing momentum behind the global push toward Net Zero.
Conversely, the US market is more leveraged to the tech led growth thematic, with major technology stocks such as Apple and Amazon making up more than a quarter of the total market capitalisation of the S&P500 index and representing 8 of its top 10 constituents by weight.
While there are of course value stock opportunities within the US market, the large concentration in growth style names trading on significant multiples highlights the better positioning of the Australian market as an opportunity to capitalise on the rotation to value. We would note that thematic influences associated with these differences have already driven a clear performance dispersion between the two markets over the year to date, with Australia’s greater value-orientation supporting outperformance relative to the US and other global markets.
With growing momentum behind the rotation back to value, we see meaningful opportunity for this relative outperformance to continue.
Reece Birtles, chief investment officer, Martin Currie Australia