2. Isn’t value dominated by financials and energy?

This is another commonly held assumption that doesn’t hold up to scrutiny. In reality, the sector compositions of the Russell 1000 style indices have shifted markedly over time, resulting in value now being much more diversified than in the past. As of 4/30/23, the growth camp is highly concentrated in technology (46%), followed by consumer discretionary (17%) and industrials (13%). Value, meanwhile, has its largest sector weightings allocated to financials (18%), healthcare (16%), and industrials (13%). So, among other things, this greater sector diversification means the value index may now be better positioned to weather a sudden, sharp downturn in any one sector.

3. Value stocks have been cheap for quite a while, so what’s different now?

Despite value’s strong performance in 2021 and 2022, broadly speaking, these stocks remain inexpensive on a simple price/earnings¹ basis. What has changed is profitability in the value space. I look at a profitability metric (free cash flow relative to enterprise value) to assess how efficiently companies are generating cash relative to their total market value.

For most of the post-GFC era, growth has scored higher on this ratio than value, but that flipped in 2020, rendering value more attractive from that perspective. Just remember that valuations alone aren’t typically a primary catalyst for outperformance by value, but they can provide support if other positive drivers are in place, particularly higher inflation and interest rates, and the ongoing transition to green energy.

Value has historically delivered some of its strongest performance runs during higher-inflation periods.

4. How exactly would higher or stickier inflation change a bullish value outlook?

If anything, it would boost my conviction in my outlook because value has historically delivered some of its strongest performance runs during higher-inflation periods, punctuated by the hyperinflation stretch the US experienced in the 1970s and 1980s. While I don’t expect today’s inflation to approach those lofty levels, I do think several macro forces could conspire to keep consumer prices elevated over the next few years: Ongoing labor and commodity shortages, post-COVID supply-chain reorganization, the broad trend toward deglobalization, and the inexorable energy transition are all elements of what could be a new higher-inflation, higher-interest-rate regime.

5. What could go wrong that might undermine this thesis?

A scenario in which the US Federal Reserve rapidly cuts interest rates, while unlikely as of this writing, could propel growth over value, given the former’s inherently longer duration. However, while an economic recession would seem like a big risk, value actually outperformed growth during the US recessions of 1960, 1973, 1990, and 2001. If I’m right though, higher-for-longer inflation and rates could assert themselves as key engines of value-stock outperformance in the period ahead.