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The case for value stocks to keep topping growth stocks for the time being

Value stocks are far more likely than not to continue outperforming

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It goes without saying that 2022 was a less-than-stellar year for equity investors given that the MSCI All Country World Index of stocks fell 18.4 per cent. There was virtually nowhere to hide, with equities in nearly every country and region suffering significant losses. Canadian stocks were somewhat of a standout, with the S&P/TSX composite index falling only 5.8 per cent on the year.

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But there was an interesting development underlying these broader market movements: value stocks far outpaced their growth counterparts. Globally, value stocks suffered a loss of 7.5 per cent compared to a decline of 28.6 per cent by growth stocks. This substantial outperformance was pervasive across countries and regions, including the United States, Europe, Asia and emerging markets. In the U.S., the outperformance of value stocks in 2022 was the highest since the collapse of the tech bubble in 2000.

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These historically outsized numbers have left investors wondering whether value has any legs left and/or whether they should now be tilting their portfolios in favour of a relative rebound in growth stocks. As we’ll demonstrate, value stocks are far more likely than not to continue outperforming.

Value is the “dog” that finally had its day

From a contextual perspective, 2022 followed an unprecedented period of value stock underperformance as the accompanying chart shows.

Although there have been (and will be) times when value stocks underperform their growth counterparts, the sheer scale of value’s underperformance in the several years preceding 2022 is almost without precedent in modern history. The extent of value’s underperformance is matched only by that which occurred during growth stocks’ heyday during the internet bubble of the late 1990s.

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Shades of tech bubble insanity

The relative performance of growth and value stocks cannot be deemed either rational or irrational without analyzing their relative valuations. To the extent that the phenomenal winning streak of growth stocks in the run-up to 2022 can be justified by commensurately superior earnings growth, it can be construed as rational.

On the other hand, if the “rubber” of growth’s outperformance never met the “road” of superior profits, then at the very least you need to consider the possibility that crazy (greed, hope, etc.) had indeed entered the building.

The extreme valuations reached by many growth companies during the height of the pandemic brought to mind a warning that was issued by a market commentator during the tech bubble of the late 1990s, who stated that the prices of many stocks were “not only discounting the future, but also the hereafter.” 

Based on forward PE ratios, U.S. value stocks at the end of 2021 were at a 56.3 per cent discount to U.S. growth stocks. From a historical perspective, this discount is more than double the average discount of 27.9 per cent since 1995 and is matched only by the 56.6 per cent discount near the height of 2000’s tech bubble.

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This valuation anomaly was not just a U.S. phenomenon, as global value stocks hit a 57.5 per cent discount to global growth stocks, more than twice their average discount of 27.6 per cent since 2002 and even larger than that which prevailed in early 2000.

Importantly, valuation is the ultimate anchor for investments. Although the process can sometimes occur at a glacial pace, there is always an inevitable pull back to fair value in the end. Investors who ignore this should heed the warning of Sir John Templeton, who stated that “The four most expensive words in the English language are this time it’s different.” 

Taking the other side of crazy

Notwithstanding value’s stellar outperformance in 2022, I am confident it will continue to outperform over the medium term for the simple reason that the valuation spread between value and growth stocks remains incredibly stretched.

U.S. value stocks were trading at a 45.2 per cent discount to their growth peers as of the end of 2022, and the corresponding discount of global value equities stood at 50.4 per cent. Assuming a reversion to their respective average historical discounts of 27.9 per cent and 26.7 per cent, respectively, U.S. value stands to outperform by 31.6 per cent and global value will outperform by 46 per cent.

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The current setup is similar to that which existed at the height of the 2000 tech bubble, which, in retrospect, was the craziest thing many investors had seen in their lifetimes. Once the bloom had come off the growth/tech rose, U.S. value stocks outperformed their growth cousins by a cumulative 54 per cent over the next seven years.

Nothing can even be certain in the world of investing. Moreover, there will inevitably be subperiods over the medium term when growth stocks outperform their far more attractively priced value peers. All investors can do is ascertain the probabilities and position themselves accordingly. Consequently, I am confident that portfolios with a strong value bias will outperform over the next several years. 

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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