Four reasons to consider value investing now

As inflation moderates and the Federal Reserve (Fed) is expected to cut interest rates in 2024, the “COVID-19 era” in the economy and markets appears to be concluding. Plus, with the decreasing chances of a severe recession, markets are broadening from the very narrow market rally in 2023 fueled by the strong performance of the handful of US mega caps — the so-called “Magnificent Seven.” Investors are now looking to reallocate cash-heavy portfolios and rebalance their equity exposure. We believe it may be time to take a look at US value stocks. Here are four reasons to consider them now.

1. Strong rotation to value¹

Value began to outperform in September 2020 after nearly a decade of underperformance compared to growth stocks. Comparing the period leading up to September 2020 with the period immediately following reveals a stark contrast. (See chart below.) The difference in performance between the most expensive (highest price/earnings) and cheapest (lowest price/earnings) stocks reflects a strong rotation to value, specifically from 2020 to the end of 2022.

The market’s least expensive stocks have been outperforming the most expensive

Average return of price to earnings (P/E) quintiles

2. Broader market participation

The stock market has been on a wild ride during the past two years. In 2022, the S&P 500 Index stumbled, returning -18.1%, but rebounded significantly in 2023, delivering a +26.3% return. During the 2023 surge, the number of stocks outperforming the S&P 500 was unusually narrow and dominated by tech companies. Only 28% of stocks in the Index outperformed it last year, a historically low number.² We don’t think this is sustainable.

Fast forward to February 2024. Consumer discretionary and industrials were the top-performing sectors, with many stocks within them hitting record highs. Restaurants, homebuilders, and travel stocks in the consumer discretionary sector contributed to the record highs. The industrials sector hit an all-time high, with nearly half of the stocks in it posting returns of more than 7%.³

Improving fundamentals and performance in various sectors and industries, combined with a favorable macro environment, may suggest broader performance this year — which could improve the odds for active fund managers. With a larger variety of stocks currently driving market returns, it’s no longer “a rising tide lifts all boats” scenario, which investors experienced in 2023 when investing in indexes like the S&P 500.

3. Moderate inflation

Some recent inflation-related data has spooked markets, but the reality is that inflation remains well under control. While no one can predict the future with certainty, historically moderate and high inflationary environments have favored value stocks relative to growth. Given the current moderate inflation rate, we believe there’s reason to expect continued value leadership.

Value stocks have outperformed growth when inflation has been moderate to high

Return difference between value and growth stocks in low, moderate, and high inflationary periods

4. Undervalued companies with improving fundamentals

Over the past few years since the COVID-19 market downturn, firms have implemented major expense reductions to preserve cash. Even when inflation was high and recession risks were rising, consumer demand remained strong, and many companies have seen a rebound in sales. We believe stronger revenues and lower fixed costs may lead to higher cash flows for undervalued businesses.

Our take on value investing

We take a highly contrarian approach — seeking companies others are ignoring. Our value investing philosophy is to seek companies with stock prices significantly below the intrinsic value of their underlying assets before the market spots the opportunity. Comparing a stock’s current trading prices to the true, intrinsic worth of the underlying company based on an objective financial measure, such as discounted cash flow analysis, helps determine if it’s under or overvalued.