Although not widely discussed, a major story of 2022 was the outperformance of the value indices vs. their growth peers across all market capitalizations. We had written in our Market Musing blogs and our quarterly letters that in our view rising rates would lead to reduced valuation levels for growthier stocks, especially those with no near-term cash flow and valuation targets overly reliant on the ‘terminal value’ of a discounted cash flow (DCF) model. Simply, if the discount rate is raised, longer duration cash flow streams are negatively impacted compared to more visible near-term cash flow streams.
While higher rates negatively impacted valuation levels for the market as a whole, we saw value indices greatly outperform their growth peers. The table below shows this value vs. growth outperformance across all market cap segments. We also include the S&P 500 ETF to illustrate our view that this index has for years skewed to the growth style.*
Value vs. Growth: We Think the First Inning Just Ended
We think the outperformance of the value style vs. the growth style will continue throughout 2023, and likely beyond, i.e. we are in the early innings. Our view continues to be that the quantitative easing (QE) policies of the Fed to keep interest rates near zero supported a period that rewarded businesses models that produced low or no cash flows and were overly reliant on external equity funding, both from equity offerings and employees who were paid in stock versus cash. With the Fed intent on raising rates until inflation breaks, we see the unraveling of these untested and highly valued business models. Conversely, for the most part, value style equities have strong balance sheets and cash flows that support current operations without external funding, and valuations that are more in line with pre-QE levels.
The Return of a Stock Picker’s Market
While we see a favorable environment for the value style, we are not suggesting broad index buying as a strategy. Our RAM philosophy incorporates not only financial strength as our first pillar and compelling valuation as our third pillar, but also a view that a successful company must have the ‘ability to grow’, our second pillar. We don’t define value investing solely on the retroactive measure of book value. We have also never believed that value was the antonym of growth, and we believe that value companies that can’t grow are the classic examples of value traps. With the increased macro headwinds of Fed rate hikes, low levels of GDP growth and persistent pockets of inflation, we believe active due diligence and analysis will be necessary to select stocks that can outperform today’s investment headwinds.
Rewey Asset Management is a registered investment advisor in the State of New Jersey
* The Russell 2000 Value, the Russell 2000 Growth, the Russell 2500 Value, the Russell 2500 Growth, The Russell 1000 Value, The Russell 1000 Growth, The Russell 3000 Value and The Russell Growth and the S&P 500 Index performance levels are sourced from Bloomberg. All of these indices are individually an unmanaged group of securities considered to be representative of the specific market-cap segments of the broader stock market. Indexes are unmanaged and do not incur management fees, costs, or expenses. It is not possible to invest directly in an index. An index is generally designed to illustrate the performance of a specific asset class (i.e. small cap), but is not actively managed and the index performance does not reflect the impact of advisory fees and other investment costs.
Past performance is no guarantee of future results. This material is for informational purposes only and is not a recommendation or advice. Investments and strategies mentioned are not suitable for all investors. No one can predict or project performance, and forward-looking statements are not guarantees. Past performance is not indicative of future results. Investing involves risk, including the loss of principal. Indices are unmanaged and you cannot invest directly in an index.