The year 2022 was a year to forget for investors, with both stocks and bonds taking a beating. It was a year of unprecedented turmoil, with inflation reaching levels not seen in decades, central banks raising interest rates at a breakneck pace, and a devastating war in Europe exacerbating an already dire energy crisis and above all leading to unimageable human suffering in Ukraine. Something on the financial markets front we had not seen in a while was the value style outperforming massively (for the reader to decide if you want to add it to the good or bad things that happened during the year). In this article we look back at the set up of 2022 which drove the value style and discuss why the style can still perform in 2023.
The value style started the year 2022 at valuation dispersion levels comparable to the dot-com bubble, creating an opportunity for value stocks to outperform. But just because an opportunity exists doesn’t mean it will materialise. In this case, the trigger for value stocks to start outperforming was interest rates moving higher. It is not always the case that the value style’s performance shows a correlation this high to the movement in rates, but it was the case in 2022. The higher inflation and rates environment created a shift in sentiment across public and private markets. A renewed focus on valuation established itself and the grow at all cost preference disappeared. The war in Ukraine intensified the energy crisis that had lingered in the background which added even more inflationary pressures throughout the year. Together with a shift in investor preference value stocks surprised more positive on earnings than their more expensive counterparts over 2022. This strong backdrop created exceptional performance for the value style, especially in the US. In US markets, energy stocks posted stellar returns and the most expensive growth stocks saw the biggest declines. By the end of 2022, we also saw the end of the “free money” era. The year was clearly marked by extreme market movements as a result.
As we enter 2023, the situation is different, though there are still several tailwinds for the value style. The valuation dispersion between value and expensive stocks is still at very elevated levels, which means there is still an opportunity for value to perform well. To contrast this attractive valuation, the underlying quality of the value basket is still in good shape, as the operating margins and debt profile are slightly better than they previously had been. The macro environment is also different than it was in 2022. We are much further into the interest rate hiking cycle of central banks, but with a cloudier economic outlook. Although taking a probabilistic view, the consensus increased its probability that a recession can be avoided even in Europe. The Chinese reopening could shift these probabilities in either direction. As the Chinese economy reopens, it could bring positive growth, but also drive-up demand for energy, which could push up energy prices. The ‘rising tide lifts all boats’ moment of value might have passed but there are still ample opportunities in a value universe. With a more uncertain economic outlook and tighter financial conditions, it will be more important than ever to carefully select value stocks and avoid those that could be “value traps.” A strong valuation discipline needs to be complemented with a view on the underlying quality of the companies with the debt and margin profile at the core.
