CONTRIBUTORS
Patrick Kaser, CFA
Managing Director & Portfolio Manager,
Brandywine Global
After the longest, deepest period of value underperformance since the Great Depression, history suggests we are overdue for an extended period during which value outperforms. There is always a “it’s different this time” story as to why the resurgence happens, but history is on the side of value investors after more than a decade of severe underperformance (see chart 1).
Chart 1: Value vs. Growth: Rolling Ten-Year Excess Return
As of December 31, 2023
By some measures, value has underperformed since 2005, and while there was a brief rally in 2022, the relative multiples of value stocks are still near all-time lows. While no valuation metric is perfect, the ratio between value stocks and growth stocks has spiked to levels that cannot be justified by differences in accounting approaches (such as the changing importance of intangible assets) or other explanations (see chart 2).
Chart 2: Ratio of Avg Price-to-Book: Russell 1000 Growth vs. Russell 1000 Value
As of December 31, 2023
Powerful momentum creates an opening for value
The outlook for value is positive both from a valuation starting point and a likely economic outlook. High-flying momentum stocks now exhibit multiples at extremes, and market concentration masks how much the average stock has underperformed. While “low expectations investing” has not worked recently, the logical underpinnings remain and any economic scenario other than “Goldilocks” may result in outperformance by the stocks that have lagged in recent years.
Market leadership has been driven by Artificial Intelligence (AI) euphoria, and investors appear to be extrapolating rapid growth for many years to come. As with the 1998–2000 tech bubble, when double-ordering appeared, investors appear to be dismissing concerns about valuations. Seasoned investors may remember that the conclusion—the Internet did change how businesses operate!—was not the same as perpetual outperformance by tech stocks. In the US, Nvidia recently had a market capitalisation greater than the entire energy sector combined. Situations like this seem to skew the odds in favor of non-tech stocks.
Behaviorally, the fear of missing out has been a powerful force. Professionals and individuals feel the need to keep up, but driving using only the rearview mirror does not lead to increased safety.
What happens if the soft landing does not happen?
Market expectations globally reflect the view that the global economy will keep growing, albeit at a slower pace, and that proof of tamed inflation will lead to a series of interest rate cuts. That said, meaningful volatility in longer-term interest rates reflects uncertainty as to whether inflation will fall as low as central banks are targeting, and history suggests that rate cuts normally come when economic trouble has emerged. Value investing is often most powerful coming out of economic troughs, given the more cyclical nature of companies represented by the style.
Over the past two years, the market has bifurcated into clear winners and losers. A handful of high-flying US tech stocks, dubbed the “Magnificent 7,” have delivered strong returns, fueled by investor enthusiasm for AI. Meanwhile, more economically-sensitive sectors like banks and cyclicals have languished amid fears of slowing growth. This divergence has produced extremely stretched valuations.
Comparison: Magnificent 7 Stocks vs. Russell 1000 Value Index
Note: Magnificent 7 include: AAPL, MSFT, AMZN, NVDA, GOOGLE, TSLA, META. Source: FactSet.
However, the outlook may be cloudier than it appears for the market’s darlings. Their meteoric rise seems to assume immunity from broader economic crosswinds, an unlikely proposition. Several risks warrant more balanced perspectives:
- The sought-after “soft landing” for the economy is not guaranteed as the fallout from aggressive tightening remains unclear.
- Declining inflation may still reverse and it is premature to claim victory.
- Interest rates could stay higher for longer than anticipated.
- Meanwhile, warning signs have emerged around consumer financial health.
By overlooking these broader threats, tech investors downplay the potential economic and market turbulence ahead. Their rich valuations appear to discount even a mild economic slowdown, much less a recession.
One of the best defences against losing money in highly- valued stocks is the question: “what happens to the price if the story I am being told does not happen?” A margin of safety is critical but often does not exist in growth or glamour investing. The arguments for value stocks can rely on both positive and negative catalysts; the valuation starting point right now contains strong absolute and relative components.
Conditions set for value outperformance
Putting the two together—valuations and the environment— the conditions look very positive, in our view, for a sustained period of value outperformance. Given that this rotation has not yet begun, investors have not missed the opportunity to rotate into the style.
IMPORTANT INFORMATION
This publication is issued for information purposes only and does not constitute investment or financial product advice. It expresses no views as to the suitability of the services or other matters described in this document as to the individual circumstances, objectives, financial situation, or needs of any recipient. You should assess whether the information is appropriate for you and consider obtaining independent taxation, legal, financial or other professional advice before making an investment decision.
Issued by Franklin Templeton Australia Limited (ABN 76 004 835 849, AFSL 240827).
© Franklin Templeton Australia Limited. You may only reproduce, circulate and use this document (or any part of it) with the consent of Franklin Templeton Australia Limited.