As stocks continue their volatile ride in 2022, investors are searching for a smoother path to attractive returns. In our view, US value stocks are a compelling opportunity that may retain their current leadership role in a less certain market backdrop. After 10 years of well-publicized underperformance, value stocks’ rebound over the last 18 months, particularly relative to growth stocks, is noteworthy.
The intensity of rising inflation and the ensuing higher interest rates portend a favorable environment for value stocks, which should provide a tailwind for the trend to continue. Higher rates tend to weigh on growth stocks as cash flows that are anticipated well into the future end up with a lower present value. Conversely, value stocks possess “short-duration” asset characteristics as they tend to realize their cash flows sooner.
Furthermore, at the sector level we find areas where a combination of attractive valuation metrics and evolving industry trends offer opportunities for stock picking. In particular, we like certain industries in the Financials and Industrials sectors. We believe there is still great value in value investing.
Value renaissance
A long-term view of the relationship between value and growth offers perspective. The chart below plots the long-term performance history of US value versus growth, with the dotted green line the average performance versus value over rolling 10-year periods back to the Great Depression. The far-right side of the chart shows just how early we look to be in the cycle for value leadership, and just how extreme the growth outperformance has been.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. For illustrative purposes only. Source: Alliance Bernstein, as of August 2022.
The next chart illustrates the historical spread in valuations between the cheapest quintile and most expensive quintile of the market—a proxy for growth versus value. Again, the far-right side of the chart shows how extreme the spread had become during Covid, which was the widest over the last 25 years. While the valuation spread has narrowed during the recovery, it remains at a historically attractive level.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Source: Bloomberg, FactSet as of 9/30/22.
Favorable valuations
What we find unique about the current environment is that higher rates and more persistent inflation seem to be the consensus, yet this outlook has not trickled down to the valuation profile of the market segments most likely to benefit. So, despite the uncertain economic outlook, we are identifying compelling value opportunities, even within more economically sensitive sectors such as Financials and Industrials.
Financials
The Financials sector has long been a beneficiary of higher rates and inflation; we believe the group is poised for resilience as the capital profile of US banks remains robust. Notably, the sector is also offering the most attractive valuations in decades.
For illustrative purposes only. Drawn from the largest 1,500 stocks; capitalization-weighted data. Source: Corporate Reports, Empirical Research Partners Analysis.
Currently, banks and diversified financials are generally exhibiting strong balance sheets and capital ratios, in stark contrast to the period during and after the global financial crisis (GFC). Furthermore, over the course of the Covid-19 pandemic, banks and diversified financials passed the US Federal Reserve’s (the Fed) stress tests, which included dire US unemployment assumptions of 15-20%. Another advantage between the current potential recessionary environment and the former GFC is the more stringent current expected credit loss (CECL) accounting standards. These rules went into effect in 2020 and are very conservative, requiring banks to provide for loss assumptions over the life of a loan immediately.
Finally, despite a slowing economic outlook, we believe loan demand can improve for the banks. As rates rise and liquidity is removed from the system, money is no longer “free,” forcing borrowers to pivot toward traditional banks and away from non-bank alternatives. We haven’t seen a meaningful corporate credit expansion in this cycle, and there are several areas within the energy transition theme that will require capital regardless of the economic environment.
Outside of banks and diversified financials, the insurance segment also offers attractive opportunities against a volatile, inflationary backdrop. The group is typically less volatile than the overall Financials sector as products are generally non-discretionary in nature. Additionally, idiosyncratic opportunities abound in life, non-life and specialty insurers as select companies seek to dispose legacy businesses with higher rate or market sensitivity, and redeploy capital into higher-margin, lower-capital intensity fee-based business.
Industrials
We have also found pockets of opportunity within Industrials, primarily in capital goods and aerospace & defense. We believe capital goods companies that will benefit from an accelerating US capital-expenditure cycle will be of interest to investors as the persistent underinvestment in our physical infrastructure stimulates action. The chart below details the concerning result of “kicking the can down the road”:
Source: Bureau of Economic Analysis, as of 8/19/2021.
The broader energy transition theme, which encompasses trends within electrification and warehouse automation, among others, is supportive of idiosyncratic opportunities within the sector. Companies with exposure to construction spending from the Utilities and Telecommunication Services sectors are poised to benefit even in a more unsettled economic environment.
Source: Climate Policy Initiative and Bloomberg Intelligence, as of 11/2/2021.
Finally, large-scale spending intentions, such as the US infrastructure plan, underpin GDP-agnostic demand conditions within the broader capital goods space. The aerospace and defense segment also offers areas of potential as global defense budgets, particular in the US and Europe, rise as a result of Russia’s continued invasion of Ukraine. Concurrently, commercial aerospace trends are continuing to improve with broader volume recovery in the airline industry, and opportunities driven by strong airliner aftermarket activity could persist even in a weaker economic backdrop.
Still finding value in value
We believe that value-oriented securities that exhibit solid earnings momentum over the coming quarters remain poised to outperform the market. Realistically, we expect that above-trend inflationary pressures and supply chain issues will create roadblocks for certain industries, and risks remain. Looking ahead, we will continue to focus on companies that exhibit valuation protection, current earnings, and cash flows that can beat expectations and pricing power in an inflationary environment. As always, we continue to look for periods of near-term volatility to identify attractive relative value opportunities.
All investments involve risk, including the possible loss of principal. Certain investments involve greater or unique risks that should be considered along with the objectives, fees, and expenses before investing.
Past performance is no guarantee of future results.
This material has been provided for informational purposes only and should not be construed as investment advice or a recommendation of any particular investment product, strategy, investment manager or account arrangement, and should not serve as a primary basis for investment decisions. Prospective investors should consult a legal, tax or financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change.
“Newton” and/or the “Newton Investment Management” brand refers to the following group of affiliated companies: Newton Investment Management Limited (NIM) and Newton Investment Management North America LLC (NIMNA). NIM is incorporated in the United Kingdom (Registered in England no. 1371973) and is authorized and regulated by the Financial Conduct Authority in the conduct of investment business. Both Newton firms are registered with the Securities and Exchange Commission (SEC) in the United States of America as an investment adviser under the Investment Advisers Act of 1940. Newton is a subsidiary of The Bank of New York Mellon Corporation. Newton’s investment advisory businesses are described in their Form ADVs, Part 1 and 2, which can be obtained from the SEC.gov website or obtained upon request.
BNY Mellon Investment Management is one of the world’s leading investment management organizations, encompassing BNY Mellon’s affiliated investment management firms and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the corporation as a whole or its various subsidiaries generally.
The information is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
Not FDIC-Insured | No Bank Guarantee | May Lose Value
© 2022 BNY Mellon Securities Corporation, distributor, 240 Greenwich Street, 9th Floor, New York, NY 10286
MARK-312039-2022-10-20