Value stocks will have a very favorable environment
We initiate a preference for value versus growth. We believe the recent rotation into value will prove more durable than the many “headfakes” witnessed over the last decade.
Part of the reason that value stocks have been so frustrating over the last several years is the fact that value companies tend to be more cyclical and more tied to economic activity. As a result, value company earnings tend to outpace growth earnings when GDP growth is above average.
However, the recovery from the financial crisis was quite sluggish, and economic activity never really accelerated enough to give value company earnings a sustained boost. We believe the situation is now very different. The next two years of economic growth will likely be the fastest twoyear period since 1985. This should be a very favorable environment for value stocks.
Interest rates will also be key. Valuations for secular growth companies got the biggest boost from the collapse in interest rates last year. But in recent weeks, growth stock valuations have started to contract as interest rates have risen. If rates rise to pre-pandemic levels, the headwinds for growth stocks will likely continue. In addition, profitability for financials – the largest sector in the value index – should improve as interest rates rise.
So even though value stocks have generated impressive performance so far this year, we think there is more to go. For perspective, growth stocks outperformed value stocks by a staggering 35 percentage points last year. So far this year, value stocks have only recouped 12 percentage points of that underperformance. Taking a longer-term perspective, even after the rally in value, the Russell 1000 Value index is still underperforming Russell 1000 Growth by 45% since 2005.
Over this period, GDP growth was generally sluggish, but the next two years could be very different.
Stick with small and mid
We maintain our preference for small- and mid-caps relative to large-caps. Smaller size segments (especially small-caps) have surged since the favorable vaccine data was announced in early November. Still, we believe this momentum can continue.
The vaccine rollout is accelerating and another large fiscal package has recently been passed. Smaller size segments are more cyclical and were disproportionately hurt during the downturn. But this greater cyclical exposure should prove to be beneficial as economic activity normalizes. As a result, earnings growth expectations are surging, easily outpacing large caps. This is the main driver behind smaller size segments’ outperformance in the early stages of most business cycles.
Despite recent strong gains for smaller segments, we believe valuations remain appealing.