So far this year US value stocks have outperformed their growth counterparts by a whopping 21% (as at 24 May). But what’s behind the rotation?
It can partly be explained by the huge spike in bond yields, which has seen the 10-year US Treasury yield rise from 1.51% at the start of the year to 2.85% at the end of May. Growth stocks derated as a result, because their distant cash flows are very sensitive to changes in discount rates.
However, a less-appreciated reason is that traditional value indices are currently concentrated in more defensive industries, which tend to benefit in stagflation environments.
So, contrary to popular belief, the value style of investing does not simply mean buying companies in cyclical sectors such as financials and energy. In fact, these sectors only account for 24% of the MSCI USA Value Index’s market cap.
The reality is that neither value nor growth indices hold a constant set of companies’ shares over time. As growth companies mature, their valuations can suffer at which point they may exit the growth universe.
Similarly, when cheaper companies begin attracting investors, value stocks may see their valuations rise and exit the value universe.
Betting on value today is a defensive trade
In general, defensive stocks tend to have a market beta of less than 1, meaning they will outperform the broader market when the index falls.
In contrast, cyclical stocks tend to have a market beta of more than 1, meaning they will underperform when the index falls.
Although value investing is often associated with cyclical companies, most “bargain stocks” in the US equity market are actually defensively tilted rather than cyclical.
For example, 75% of the market cap in the MSCI USA Value Index has a stock-level market beta less than 0.9 (i.e. low beta), compared to only 15% for the MSCI USA Growth Index.
This was not always the case. In the past, value’s defensive exposure was much lower and its cyclical exposure was much higher.
In 2009, around 41% of value’s market cap had a beta less than 0.9, while 44% had a beta greater than 1.1.
In other words, investors should not assume anything permanent about value’s cyclicality and the prevailing market environment illustrates this point very clearly.
Looking ahead, any bet on future performance should factor in this economic tilt.
