The value of the value is still compelling

Avalon_Studio

By Sam Peters, CFA

Still at the beginning of a strong value cycle

There is no absolute measure of time and space in physics. Rather, as we know thanks to Einstein, everything is relative, events influence each other. The financial markets are similar have no absolute measure of time and most things are actually compared relative to each other. As a result, each market cycle is unique and the variability in time between events is one of the great challenges of investing. What we do know, however, is that markets regularly oscillate between hope and fear, and that key events within this arc of human emotion tend to repeat themselves under similar conditions. With relativity in mind, we think it’s worth looking back at the big events of 2022 and what they hint at for the big opportunities in 2023.

The first big change we saw is that everything got cheaper as multiples got compressed. On an absolute basis, the Russell 1000 Growth Index (RLG) multiple fell just over 30%, while the Russell 1000 Value Index (RLV) fell almost 15%.

As in physics, however, it is a matter of relative measure. Despite growth ratings falling twice as much as stock, stock’s relative value remained well above historical averages and remained in the cheapest decile (Figure 1). The key observation here is that relative performance moves between growth and value styles have never stalled at these levels. Market cycles are here to an end, and there is still a long way to go in favor of value in this current market cycle.

Given how painful 2022 felt, especially for growth investors, it might seem hard to believe that growth hasn’t progressed further. To be clear, progress has indeed been made, but what has been worked off is just the investor surplus. Unfortunately, there is still a long way to go before fear is priced in.

Figure 1: Value remains historically undervalued

As of December 31, 2022. Source: Bloomberg Finance, LP, ClearBridge Analysis.

We look at market price movements as a function of valuation and fundamentals, and within valuation we attempt to identify any changes in the risk-free rate (the 10-year Treasury yield) and the equity risk premium. Throughout 2022, almost 100% of the change in the market’s valuation multiple was solely due to the movement in interest rates, leaving the equity risk premium essentially flat. Another surprising observation from the year is that fundamentals did not weigh heavily on performance; RLV’s revenue increased 5%, while RLG’s revenue increased 1%. In other words, the pain investors felt was almost entirely the rise in the cost of capital as the Fed hiked interest rates.

Figure 2: Cost of capital dependent on the risk-free rate

As of December 31, 2022. Source: Bloomberg Finance, Damodaran Online.

One of our key tactics as valuation-disciplined managers is to monitor valuation spreads and capitalize on them when they become historically wide. Similar to high yield spreads and volatility indices, valuation spreads typically explode higher during a recession. Current valuation spreads are not much above average historical levels (Figure 3), further evidence that fear is not yet priced into the markets. While Value’s value relative to growth still massively favors Value as a major opportunity in the current market cycle, most US stocks are not historically cheap and are not harboring a recession on an absolute basis.

Figure 3: Valuation ranges close to historical average

As of December 31, 2022. Source: National Bureau of Economic Research, Empirical Research Partners Analysis.

If the Fed does trigger a recession, valuation spreads will likely follow historical precedent and close a gap. While the stocks unfortunate enough to push spreads higher change with each event, the list usually consists of past cycle winners who lost their glory due to forced selling due to excessive leverage or deteriorating fundamentals. Yesterday’s heroes become today’s villains when excess is eliminated. We believe this will be the case again, with distress most concentrated in equities, which were the biggest beneficiaries of the free capital era, and excessive speculation by investors armed with leverage and derivatives. The tactical opportunity to seize, however, comes when stock correlations spike during risk events and good stocks are discarded with bad. But just because a stock is down 50% doesn’t make it attractively cheap. To avoid anchoring expectations, we rely on our rigorous valuation discipline to help us navigate the carnage and find attractive stocks when nobody seems to want them.

Sam Peters, CFA is a portfolio manager and co-manager of the Value Equity Strategy and the All Cap Value Strategy and has over 30 years of investment experience. Sam earned a BA in Economics from the College of William & Mary and an MBA from the University of Chicago. He received the CFA designation in 1997.