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Q&A: A Cogent Case for Value

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A Cogent Case for Value

Key Takeaways

  • This new market cycle of higher interest rates and greater fiscal spending is unequivocally good for value but is being largely ignored due to the focus on AI and an economic soft landing.
  • We believe the market’s attention on large growth stocks has created an attractive value menu, particularly in energy, insurance and IT hardware manufacturers.
  • The relative value of value versus growth is back to all-time highs, suggesting value stocks will have an edge over the cycle and making an investment case for a healthy value allocation.

An Interview with Sam Peters

After strong performance by growth in the first half of 2023, greater macro uncertainty and the prospect of a higher-for-longer interest rate environment has shifted investor attention toward the opportunities in value stocks. We recently sat down with Portfolio Manager Sam Peters, CFA, to discuss why he thinks current market conditions make a cogent case for long-term value investing.

Year to date, the Russell 1000 Growth Index has outperformed the Russell 1000 Value Index significantly. Do you believe the growth rally is overstretched? And if so, what would a pullback mean for value stocks?

It’s very normal for growth to have a rebound. Obviously, value did very well last year, and growth not so much. But then, coming into this year, we had two big surprises: the regional banking crisis in March and artificial intelligence (AI), as ChatGPT came on the scene. The result has been a big rebound in valuation multiples for growth, with both earnings growth and multiples up about 10%.

The key is determining what happens going forward. Things have drastically changed from the FAANG cycle, which was a huge growth driver. The continued rise in interest rates and an era of free money, I think, is completely over. This is unequivocally a good thing for value, but it’s being completely ignored by all the focus on AI and the prospect of an economic soft landing. The relative value of value versus growth is back to all-time highs, suggesting value will have an edge over the cycle. I think we’re in a great time to balance out the rebound with a healthy allocation of value. There are lots of opportunities for active managers willing to look beyond the top of U.S. indexes, and value is a great lens to do that with.

Where are you finding the best opportunities in value stocks right now?

The value menu right now is pretty attractive, and you can get a great seat at the table because everybody’s focused on the top growth stocks in U.S. indexes.

One of the sectors we are most bullish on is energy. Many energy companies currently fit the bill, with double-digit free cash flow yields, and some even rising above 20%, allowing you to get your capital back in about three or four years. We’ve also seen incredible capital discipline in the sector focusing on improving free cash flow. This gives us a free option on the structural underinvestment in energy, along with higher prices. Many of these stocks then have the highest dividend yields and buyback yields in the market, resulting in returns on capital that are the second highest after tech. After two years of leading market returns, energy’s taken a break this year, but even as the price per barrel dipped down into the $70s, free cash flow and returns were still very healthy. So, the fundamentals are there, and even if one or two more things improve, we think the sector can do even better.

Insurance stocks are also big for us. We currently see them following the same pattern through rising pricing power due to a shortage of insurance capital and removing risks out of their business models, leading to better returns and positive pricing. Additionally, despite a crazy macro environment, we are seeing opportunities in the dynamic random-access memory cycle, which is related to both AI as well as consumer goods.

You have recently discussed how tech transitions are historically unsteady. Could you elaborate on what you mean by that?

AI is going to be massively transformative over time. We saw this with the Internet back in 2000, which has been a bigger deal than anyone thought, but still took about 10 years to reach maturity. And, while the long-term winners like Amazon emerged in a big fashion, there were also lots of extinctions, a lot of Pets.com along the way.

One example of the challenges we’re seeing is supply chain issues. To start, you can’t get enough advanced processors, but I’ve also heard companies struggling to get the skilled labor and having to find ways to manage increased energy demand. So, there’s lots of bottlenecks. In other areas, we’re going to overbuild. We’ve also gotten used to digital disrupting analog, the way Amazon pushed out retailers like Sears. This time, large tech will be hunting each other, and there’s going to be these new, AI pure-play entrants, which will challenge the legacy tech players where all the capital is going.

The issue I have is that hype cycles are still cycles; they’re not linear and they still take time to culminate. I think there will be huge opportunities once the hype cools and we see the actual impacts of AI.

Let’s go back to the value of value being at historic highs relative to growth. Could you elaborate? Why is there a compelling case for investing in value right now?

Throughout my career, I’ve seen the market rotate between growth and value, in cycles typically lasting 10 to 15 years. The key is that the winners of the new cycle, no matter whether they’re growth or value, all begin incredibly cheap. So, the way we measure this is: how are value stocks valued relative to growth? Before the FAANG cycle, growth stocks were at all-time record lows relative to value. However, that reversed itself and, during COVID, value got to the cheapest it had ever been. Some of that got worked off last year but, with growth roaring back this year, we’re back to near the all-time highs in value of value. So, I suspect that we’re set up for a very big value cycle.

Exhibit 1: The Value of Value Returns to Historic Highs

Exhibit 1.jpg

As of September 30, 2023. Source: ClearBridge Investments, FactSet.