2023-09-20 09:42:49 ET
Summary
- Value stocks had a fantastic 2022, and a lackluster 2023.
- Recent market gyrations have changed value fundamentals in several key ways.
- Three recent value trends stand out.
It has been an eventful couple of years for value and growth stocks. Value stocks had one of their best years this past 2022, as skyrocketing inflation and higher interest rates made investors re-assess the merits of tangible businesses with strong, present cash-flows. The trend reversed this year, as economic conditions stabilized and investor sentiment improved. Considering recent market gyrations, thought to analyze how value stock fundamentals have evolved these past two years. I've identified three key recent value trends.
Recent value underperformance was driven by the outstanding results of a couple growth stocks, including Nvidia ( NVDA ) and Facebook ( META ), and weakness in several value sectors, chiefly financials.
Valuation gaps between value and growth stocks are significantly wider than average, albeit a bit narrower than past year, and much narrower than during the dot-com bubble.
Value earnings growth seems weaker than in the past, especially in comparison with growth stocks. Value stocks should have lower growth, however, so this is in-line with expectations.
In my opinion, value stocks are strong investment opportunities right now, due to their competitive, historically cheap valuations.
I'll be focusing on the Vanguard Value ETF ( VTV ) for the remainder of this article, but everything here should apply to most U.S. value funds, and to said securities more broadly.
VTV - Quick Overview
VTV is an index ETF tracking the CRSP US Large Cap Value Index , a broad-based U.S. large cap value index. Applicable U.S. equities are initially selected based on a basic set of inclusion criteria. Securities are then ranked according to their valuation, and stocks with below-average valuation are included in the index. Valuations are determined according to the four following standard metrics:
VTV Value Factors
VTV's underlying index is quite broad, which results in a well-diversified fund, with investments in 343 stocks from all relevant industry segments. As is the case with most value funds, VTV is overweight old-economy industries like financials and industrials, while being underweight growth, tech, and telecommunications.
In my opinion, VTV is broad enough, diversified enough to function as a benchmark for U.S. large-cap value stocks. These securities have seen significant changes to their fundamentals these past two years. Let's have a look at these.
U.S. Large-Cap Value Trends
Recent Value Underperformance
Recent S&P 500 gains have been almost entirely driven by the performance of just five growth stocks : Nvidia ((NVDA)), Amazon ( AMZN ), Google ( GOOG ), Microsoft ( MSFT ), and Apple ( AAPL ). Nvidia has been the standout, with a whopping 198% in returns YTD, but its peers have seen very strong returns too.
Most value indexes and funds, including VTV, exclude the companies above, and so have seen lower capital gains YTD, underperforming broader equity indexes. The gains above were mostly a recovery from significant losses in 2022. Nvidia has seen skyrocketing revenues, earnings, and share prices, due to increased data center demand, and the ongoing development of AI. Excluding Nvidia, I have no reason to believe that the trend above will continue.
Some of VTV's largest industries have underperformed YTD too, negatively impacting the fund. These include financials and healthcare. Industrials too, although less so.
Financial losses were almost entirely driven by the regional banking crisis which started in March. Financials were actually very slightly outperforming before the crisis hit and tumbled down in the days after. This is very noticeable in the graph above, with the purple line nose-diving a couple days after March.
Although recent value underperformance has been undoubtedly a negative, I'm not sure that it indicates any fundamental weakness in the sector, nor that it will persist moving forward. The regional banking crisis has mostly abated and recent tech gains were mostly a reversion to the mean / recovery from past losses. Health care earnings do seem weak, I discuss in more detail later one, and I can't really comment on Nvidia.
Wider Valuation Gaps
Value stocks are, by definition, cheaper than average, and cheaper than growth stocks. How cheap varies, with value stocks sometimes trading with significant discounts, sometimes smaller ones. Right now, value trades at a 46% discount to growth stocks, compared to a historically-average 29% discount. Valuation gaps are much wider now than in the past, although these were even wider during the dot-com bubble.
JPMorgan Guide to the Markets
Wide valuation gaps benefit investors in two key ways.
First, valuation gaps can always narrow, leading to significant capital gains and market-beating returns. Valuation gaps narrowed in 2022, the recent uptick in the line above, leading to market-beating returns for VTV said year. Valuations narrowed mostly due to losses in growth, tech, and adjacent industries, not due to value gains .
Data by YCharts
Although the trend above reversed itself this year , value has had a strong showing these past couple of years. VTV itself has outperformed these past three years, and since 2021. The latter seems more important / pertinent for investors, as it excludes some of recovery from the pandemic in late 2020.
As valuation gaps remain quite wide further gains and outperformance is possible and, in my opinion, likely.
Second, wider valuation gaps increase the relative effectiveness of value buybacks and dividends. In simple terms, cheap valuations means low share prices, which boosts the yields received by investors. VTV currently yields 2.5% compared to 1.5% for the S&P 500, so this is a very small, but positive, effect.
At the same time, low share prices allow companies to buy back more of their stock for the same amount of cash, boosting the positive impact of buybacks on EPS and (in theory) returns. From looking at VTV's underlying industry exposures, it seems that the overall impact of this is quite small. Financials and industrials, two of the fund's largest industries, are engaging in slightly above-average buybacks. Energy and communications have the highest buyback yields, but the fund does not significantly invest / overweight either. Still, low share prices does boost the effectiveness of these buybacks.
Wider valuation gaps benefit VTV, its investors, and those in most U.S. value stocks.
Value Earnings Growth
Value stocks trade with discount valuations for a reason and, in many cases, that reason is slow growth. There are exceptions, however, and 2022 was one. Tech saw declining earnings during the year, as did most mega-cap tech stocks.
Value stocks fared a bit better, although the big winners were energy and commodities companies. VTV is overweight both, but not significantly so. Still, during 2022 investors could choose between growth stocks experiencing declining earnings, or cheap value stocks with real, tangible cash-flows, and some slow growth.
The situation is very different right now, with most growth stocks seeing positive earnings growth YTD, especially these past few months (see above). Expectations for future growth are reasonably good too, with analysts expecting 8.4% earnings growth for the next twelve months, 17.4% for telecommunications. Expected growth for most value industries is positive too, but generally lower.
Slower value earnings growth, or slower growth vis a vis growth stocks, is obviously a negative for value investors. Still, growth stocks are supposed to experience strong earnings growth, so this is in-line with expectations.
Conclusion
Value stocks have had a tumultuous couple of years. Three recent trends stand out.
Valuation gaps between value and growth stocks are much wider than average.
Value underperformance was driven by the outstanding results of a couple growth stocks, and some underperformance in the financials and health care segments.
Value earnings growth seems weaker than in the past, especially in comparison with growth stocks.
In my opinion, value stocks are strong investment opportunities right now, due to their competitive, historically cheap valuations.
For further details see:
3 Recent Value Trends Impacting VTV