Value has outperformed growth significantly this year. The MSCI World Index is down by over 20% but within that, the MSCI World Growth Index shrank by 30% while the MSCI World Value Index declined by just 13%.
While the decline in growth stocks has been broad based, value’s performance has been much more uneven. The main driver of its outperformance has been the jump in energy stocks, while some defensive sectors like utilities and consumer staples, which tend to benefit from resilient demand, also aided relative returns. By contrast, the cyclical value sectors like financials and industrials suffered more than the value average as investors worried about the risks of a recession.
Will value’s outperformance continue? Looking at both the key upside and downside scenarios that we face, we think the likely answer is yes. Within our downside scenario, a further escalation of the conflict in Ukraine could put further upward pressure on commodity prices and, in turn, energy stocks (although investors do need to be watchful of governments tempted by windfall taxes). In a more positive scenario, whereby global cost pressures ease and the economy proves resilient, the more cyclical areas of value have potential to catch up, particularly financials, where the combination of higher interest rates and solid loan performance could cause a re-rating of the sector.
It should also be noted that despite recent moves, the valuation gap between the two styles remains considerable. Exhibit 13 shows that at the height of the pandemic in 2020, the trailing price-to-earnings (P/E) ratio of the MSCI World Value Index was just 42% of the equivalent for growth stocks. Today the P/E ratio is still only half that of growth stocks, which is the same ratio seen in 1999 on the eve of the tech bubble bursting and well below the 70% average of the entire period.
The appeal of dividends may also tempt investors towards value stocks. The average dividend yield of the value index is more than 3%. Although government bond yields have risen, the coupons are fixed and therefore do not offer the inflation protection that corporate dividends potentially could.
Exhibit 13: Value stocks appear historically cheap vs. growth stocks
MSCI World Value and Growth valuation gap
The relative performance also depends on the prospects for growth stocks, which face two ongoing uncertainties. Firstly, the earnings prospects of companies in this category are particularly hard to forecast right now. The pandemic coincided with a rapid adoption of technology which led to a large upgrade in earnings expectations (Exhibit 14). But some stocks – such as streaming services – are struggling to meet these lofty expectations. Secondly, it remains a risk that interest rates rise further if economic activity and/or inflation rise further which has the potential to weigh on longer-duration growth stocks. However, such a broad sell-off is also providing selective opportunities to obtain good growth companies at better prices. The challenge for investors will be to find compelling innovative companies without overpaying.
Exhibit 14: Earnings growth estimates for growth stocks rose significantly during the pandemic
MSCI World Value and Growth 12-month forward EPS
Fundamentally, we believe the combination of the pandemic and war in Ukraine has shifted us into a new growth, inflation and interest rate regime. The low growth, low inflation and low interest rates of the last decade, which provided the foundations for growth stocks’ phenomenal outperformance now looks to be behind us. In our central scenario, whereby economic growth demonstrates a degree of resilience, value’s outperformance could have further to run.