European Value Equities - Can the value rally continue?

After a disappointing start to the year, the value investment style has recovered and has been outperforming growth. Fund Manager Richard Halle examines some of the potential reasons for this style rotation, including weaker-than-expected economic growth in China and higher oil prices. With value on track to outperform growth for the second consecutive year, Richard asks whether we are now in a world where it is the growth rallies that falter, rather than the value rallies.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.

Value back on track in Europe

My Global Value colleague, Shane Kelly, recently wrote an interesting note discussing the performance of the growth and value styles in 2023. He observed that although in headline terms growth has strongly outperformed value globally, there are very clear indicators that, beneath the surface, value is bubbling away remarkably well – not least of all in Japan where my colleague, Carl Vine, is taking full advantage.

What about the European perspective?

Firstly, we wanted to remind readers of our underlying hypothesis, which we initially set out in the middle of the craziness of the Covid pandemic in 2020. Our view was that the extreme style divergence that year was a capitulation phase whereby the market went all in for growth. We felt that was likely to mark the end of a sustained period of growth outperformance.

It was our contention that the 2020s would be the decade for value (the ‘cheap asset decade’): not only would valuation spreads narrow, but also a ‘regime change’ would occur where a very different world in the 2020s would see very different stocks doing well and badly.

This was potentially validated by the performance of value in 2022, where it had one of its best ever years in history.

However, this was only a partial validation. Merely one year of value outperformance still left value open to the (highly successful) strategy of ignoring value whenever it has a rally – for well over a decade those rallies being infrequent and short.

Indeed, this is what transpired in the first few months of 2023 – the growth/quality factor performed very well due to a combination of factors, including some excellent earnings reports from growth stocks; the hype around artificial intelligence (AI); and not to mention Danish healthcare company Novo Nordisk seemingly solving the world's obesity and cardiovascular problems; as well as China reopening surprisingly abruptly from Covid which was a huge boon for the large and important growth sector of luxury goods.

However, as Europe returns from its summer break, something quite interesting is happening: value has clawed back all its underperformance this year and, as at the end of September, has now outperformed growth over the year to date.

Perhaps the post-covid, post-property bubble Chinese consumer isn't going to be buying as many handbags, Mercedes-Benz cars or flashy watches as before. Maybe all those European capital goods companies which are viewed as high-quality ‘structural growers’ might not be viewed as such without the Chinese growth miracle in place.

And maybe the European banking sector is in a much better place, and is not going the way of Silicon Valley Bank, the US lender which collapsed earlier this year. And with oil back up at US$95 and refining margins for many petroleum products at historically high levels, maybe oil & gas stocks are not in violent structural decline just yet.

Maybe in a world where there is a proper cost of capital, we are going to be reminded, for the first time in a while, that valuation actually matters again.

Figure 1: Value has recovered after weak start to the year

Past performance is not a guide to future performance

And if this growth rally does indeed falter, we think it will be hugely significant because it would be the second one in short succession (the first was in the middle of last year). As you can see from the accompanying chart, growth has spent almost every part of every year since 2013 outperforming value.

But after the performance in 2022 and now in 2023 some are seriously asking the question: "what if we are now in a world where it’s the growth rallies which fail?".

We know the answer to that question – there are very few portfolios positioned for that eventuality.