In an Inflationary Environment, Value Stocks Offer a Refuge
Persistent inflation and rising interest rates are giving value stocks an edge over growth equities.
Value stocks had a banner month in December, even as high inflation dampened investors’ hopes for outsized returns.
Inflation rose 7 percent last month from the same period in 2020, up from November’s 6.8 percent year-over-year increase. As prices rose consistently throughout 2021, all value sub-factors outperformed the market at year end, according to Investment Metrics, a provider of analytics and data. Stocks with a high earnings-to-enterprise value ratio, for example, exceeded the market by 2.4 percentage points. Other value sub-factors, such as earnings yield, cash flow yield, and sales-to-price ratio, also outperformed the market by at least 2 percentage points.
Most growth sub-factors, on the other hand, were outrun by the market, which grew by 3.4 percent in December. Stocks with high growth in earnings and sales lagged the market by 70 basis points and 120 basis points, respectively, according to Investment Metrics. At the same time, December’s large interest rate rise of 6.2 percent (the U.S. 10-year constant maturity rate went from 1.42 percent to 1.52 percent) was accompanied by the strong outperformance of value sub-factors over growth sub-factors. “The average spread between Value and Growth in December was 2.5 percent, consistent with our research showing that the value-growth spread consistently widens whenever U.S. rates rise more than 5 percent in any month,” the report said.
Damian Handzy, head of research and applied analytics at Investment Metrics, told Institutional Investor that “the more interest rates go up, the more value [stocks] win.” Because growth stocks rely on long-term gains, they suffer more from the discounting effect of rising interest rates than value stocks do. Handzy added that one of his company’s 2021 studies has shown that value stocks would outperform growth stocks by 100 basis points for every 10 percent rise in interest rates.
Chris Brightman, chief executive officer at Research Affiliates, wrote that investors should “position their portfolios for a high-inflation environment by allocating to value stocks.” He noted that investors should think long-term because inflation is unlikely to die down in the near future. This is because the central bank has reached the limit of what its monetary and fiscal tools can do to restore price stability. Nominal interest rates, he added, cannot rise above inflation in G7 countries, given their elevated debt levels during the pandemic. While governments can also raise taxes to curb inflation, they might have little motivation to do so, since “sustained inflation may be the expedient political path to diminish the real value of excessive public debt,” according to Brightman.
“Without relying on aggressive valuation-reversion assumptions, we are forecasting value stocks to deliver long-term real returns exceeding 6 percent in the U.S. market and in the 8-10 percent range for the Japanese, European, and emerging markets,” Brightman wrote. He added that value stocks around the world “offer exposure to the cyclical sectors of the economy that tend to benefit from reflation.”
Indeed, according Investment Metrics, value stocks not only emerged as an attractive investment opportunity in the U.S., they also exceeded market benchmarks in emerging markets and other developed countries. In Europe, all value sub-factors outperformed the market by at least 60 basis points, while two growth sub-factors — earnings growth and sales growth — lagged the market by 20 basis points and 70 basis points, respectively. In emerging markets, value sub-factors delivered returns ranging from 2.6 percent to 2.8 percent, all well above the market average of 2.1 percent.
“As inflation soars, value stocks around the world offer a safe haven for investors, [thanks to] their outstanding forecasted long-term real returns,” Brightman concluded.