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May 23, 2022 | GSAM Connect

Navigating the New Market Regime: The Merits of Value Equities

The old saw that Value investing beats Growth investing actually has held true over an extended investment horizon: since common inception in 1978, the all-cap Russell 3000 Value Index has outperformed the Russell 3000 Growth Index, and with lower volatility.

However, the last 15 years have defied this paradigm. Through April 2022, Growth outperformed Value by nearly 5% on an annualized total return basis and in 11 of the last 15 calendar years. Here’s our take: US policy makers probably erred coming out of the Global Financial Crisis by not complementing loose monetary policy with sufficient fiscal stimulus to repair the economic damage. As such, the subsequent economic recovery was the longest—but also the slowest—in post-World War II history.

Value stocks tend to thrive in a constructive economic backdrop. However, in a slow and disappointing growth environment, many investors will place a premium on stocks of companies capable of growing revenue and earnings in a vacuum, regardless of gross domestic product growth. In this context, the recent dominance of US equity market returns by the so-called FANGMAN1 stocks of companies that helped change the way we communicate with friends and family, shop and pay for things, spend our leisure time, and consume and store data, makes sense.

What's Old is New Again

But 2022 may actually mark a regime change: the return of Value investing long foretold, but basically unrealized over the last decade and a half. Considering monthly returns over the last 20 years, January saw one of the largest differentials in style returns, with Value outperforming Growth by a wide margin. Previous moves of this magnitude in the last two decades have favored Growth. This “Value beats Growth” effect has been evident across the market cap spectrum so far this year but has been especially pronounced in mid/small cap stocks and international equity markets. This dynamic was spurred by the prospect—now realized—of accelerating Fed monetary policy tightening to combat a strong labor market, robust consumer spending, and the highest inflation prints in 40 years.

Value was aided by strength in interest rate beneficiary sectors such as Financials and pro-cyclical Energy. Meanwhile, rising rates have eroded conviction in “long duration” growth stocks—particularly in Information Technology—with strong prospective cash flows in the distant future, now discounted back to the present at higher rates. Those factors casting doubt on the high growth/high multiple side of the market (not just Fed policy, but also geopolitical risk) might persist for a considerable period of time.

What Value May Offer

After a lengthy period of exceptional performance from Large Cap tech, we believe that most investors are over-allocated to US large caps, and by extension, Growth. Value may provide a remedy. Even apart from valuation advantages (lower), Value equities may provide key benefits in the current macro environment of rising rates and elevation inflation:

  • More yield. Value equities tend to yield more than their Growth counterparts across the US market cap spectrum and in the International and Emerging Markets realms. In the more volatile market landscape we anticipate, it may be wise to generate a greater proportion of return from more predictable income, versus more volatile capital gains.
  • Adding cyclicality. In a rising-rate and high-inflationary environment, Value strategies generally may enhance returns, owing to structurally higher exposure to interest rate beneficiaries (including Financials) and Real Assets (such as Energy and Real Estate). The sector allocation disparity between the Russell Mid Cap Value benchmark and the S&P 500 is particularly striking (see below).

EXHIBIT 1: Russell Mid Cap Value Index – select sector weights relative to S&P 500

Source: Morningstar Direct, 3/31/2022

 

  • Outperformance during rising rate periods. The Value vs. Growth performance differential so far in 2022 underscores a historical truism: Value indexes tend to outperform their Growth counterparts across the market cap spectrum during rising rate periods (see chart). Also, mid/small caps tend to outperform large caps, which today are dominated by a handful of mega-cap tech stocks. This may be an artifact of the cyclical bias of Value or investor preference for the generally more certain near-term robust cash flows of Value equities, or both.

EXHIBIT 2: RUSSELL STYLE BOX INDEXES: AVERAGE PERFORMANCE DURING RISING RATE PERIODS

Source: FactSet: data based on 11 periods of rising 10-Yr UST yields, starting in 1996. Rising rates refer to periods where 10-Yr UST yields increase by 75bps or more within a 3-month period. Data reflects average returns over the period. Data not annualized. Each period reflects maximum length of 3-months. Past performance does not guarantee future results, which may vary.

 

For these reasons, now might be an opportune time to implement a rebalancing, or even an overweight allocation to Value across various equity portfolio sleeves. Such a shift may help address new market realities that may inform a medium-term investment landscape very different from the last decade.

 

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About the Author

Timothy Ramsey, CFA

Timothy Ramsey, CFA

Equity Strategist, Goldman Sachs Asset Management

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