A sustainable value rally?

2 min read 7 Feb 22

Global stockmarkets in general have fallen sharply so far in 2022, with investors rattled by the Federal Reserve’s plans to raise interest rates. One of the few parts of the market that has been able to defy this trend and hold above water is European value stocks.

The sell-off in the US has been led by large technology stocks, which have driven the market in recent years but are now being impacted by the prospect of higher rates. In contrast, the value factor, or style, has performed well this year as investors have shifted from high-flying growth stocks towards cheaper value companies.

As value investors we welcome this development and think market participants should seriously be asking themselves the question: Is this value rally sustainable or will it be another blip?

Extreme valuation dispersion driven by behavioural factors

The 13-year long trend against value as a style accelerated during the COVID-19 pandemic, albeit with a brief pause, and has resulted in a situation where the valuation dispersion between the cheapest and the most expensive stocks in the market is now as extreme as at any time in history.

Our assessment is that this market pricing has been driven primarily by behavioural factors, more than underlying company fundamentals: a self-reinforcing cycle of a long-run trend combined with an anchoring bias extrapolating these trends indefinitely, driving parts of the market to ever higher valuations. The ‘story-telling’ narrative has blown away any valuation boundaries with retail, quantitative and passive investors all crowding into the same stocks; leading to unsustainable price formation.

In other words, the price had become a strong factor in investors pilling into certain parts of the market, ignoring valuations. As a result, we think the valuations of many growth, high return and ‘concept’ stocks are excessive and it is hard to see how the fundamentals justify such a wide valuation discrepancy.

The decade of the ‘cheap asset’?

The current correction is likely to be shocking for many trend-following investors, and the pain of this experience could finally break the cycle of indiscriminate buying we have seen. After the big falls among concept and growth stocks, and with tighter monetary policies likely this year, we could well see investors starting to ask what price they should be paying for highly-valued businesses in many different areas.

We have long argued that the valuations of growth stocks were excessive and value would return to favour – in mid-2020 we suggested that the 2020s could well be the decade of the ‘cheap asset’. It has taken until now and the prospect of rate hikes to prompt a change of sentiment. As the era of cheap money seems to be coming to an end, we feel even more comfortable with our assessment of the environment in this decade.

Investors will pay greater attention to fundamentals and will pay attention to valuation anchors. This will be the most favourable development for out-of-favour value stocks.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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