Investing is about keeping up with trends. Here's what to keep in mind for 2022: Value stocks will most likely outperform their growth peers.
The trend is already underway. Consider:
* The exchange-traded Vanguard S&P 500 Growth Index
YTD down 5.6% while the Vanguard S&P 500 Value Index Fund
* Value groups like banks and energy stocks are crushing growth stocks like Ark Invest's favorites. The KBW bank index
and the Energy Select Sector SPDR ETF
have increased by 6%. In contrast, the ARK Innovation ETF
has fallen by over 13%. This ETF is full of growth favorites like Tesla
and Zoom video communications
Here's a look at four forces favoring value over growth, followed by 14 value stocks to consider, courtesy of two value investing experts.
1. Rising interest rates favor value stocks
Many investors use the Net Present Value (NPV) model to value stocks — particularly high-growth stocks that expect earnings in the distant future. This means they discount the projected earnings to the present using a discount rate, typically the yield on 10-year government bonds
As the discount rate increases, the NPV decreases.
Of course, if 10-year yields rise as they are now, expensive stocks in areas like technology will underperform the cheapest stocks in areas like cyclicals, financials and energy, says RBC Capital Markets strategist Lori Calvasina.
Likewise, the price-to-earnings multiples (P/E) of the most expensive stocks are inversely correlated with 10-year yields during Federal Reserve rate-hiking cycles, she points out. The opposite is true for value stocks.
"The cheapest stocks have historically outperformed the most expensive stocks when the 10-year yield increases," she says.
Yardeni Research's Ed Yardeni predicts that the 10-year yield could rise to 2.5% by the end of the year from around 1.79% currently. If he's right, it suggests that the value outperformance will continue. Although there will be counter-rallies in growth and tech along the way (more on that below).
Here's a chart from RBC Capital Markets showing that the stock has a history of outperforming as yields rise. The light blue line represents bond yields and the dark blue line represents cheap stock performance relative to expensive stocks.
2. Higher inflation is positive for value strategies
This has been the case in the past, points out John Buckingham, a value manager at Kovitz Investment Group who writes The Prudent Speculator's stock letter. He now expects a repeat. Part of the reason for this is that fears of inflation are driving up 10-year yields and creating the adverse NPV effect for growth stocks (described above).
Inflation accelerated in December at the fastest rate since 1982, the government reported on Wednesday. It was the third month in a row that annual inflation exceeded 6%.
But another factor is at work. In inflationary times, companies with real profits can increase their profit margins by raising prices. As a group, value companies are typically more mature, which means they need to improve their earnings and margins. Investors are noticing this and are attracted to these companies.
In contrast, growth stocks are characterized by expected earnings, so they benefit less from price increases.
"Growth companies don't make money, so they can't improve their margins," says Buckingham. "They pay employees more, but they don't make more money."
Here's a chart from Buckingham showing that historically, value stocks outperform when inflation is high.
3. Value stocks do well after recessions
This has been the case in the past, as you can see in the chart below from Bank of America. This is most likely because inflation and interest rates tend to rise during an economic recovery. Both trends are negative relative to value for growth stocks for the reasons outlined above.
4. Value stocks fare better as Covid cases fall
This has been the case throughout the pandemic, as you can see in the chart below from Bank of America. This is likely because the outlook for the economy is improving as Covid cases fall, suggesting inflation and interest rates will rise – both making growth historically value-lagging. Omicron is spreading so rapidly that case numbers are expected to peak in late January. This effect can therefore set in soon.
In the graph below, the light blue line is the number of Covid cases. The dark blue line is the relative outperformance of Growth to Value. When the dark blue line slopes down, it means value stocks are outperforming growth stocks.
Which stocks to prefer
Cyclical names, banks, insurance companies and energy companies populate the value camp. So these are the groups to consider.
Buckingham suggests these 12 names, most of which are in the above sectors: Citigroup
Pinnacle West Capital
Bruce Kaser of Cabot Turnaround Letter counts Credit Suisse
in banking and drill quip
Energy is among his favorite stocks for 2022. He is bullish on value stocks after enthusiasm for 'concept stocks' shattered.
"Concept stocks are well above bid, and that's when the value is at its best," he says.
While concept stocks fail, value companies keep working and posting actual gains, so money goes to them. That's how it was long after the tech bubble burst years ago.
"For a decade after 2000, Value has outperformed," he says.
No doubt there will be countertrend reversals along the way.
"These rotations tend to flatten out when both sides of the rotation are overdone," says Art Hogan, chief strategist at National Securities.
Here's a factor that could cool the rotation temporarily in the short term. Investors are about to learn that first-quarter growth takes a hit as Omicron quarantines hurt businesses. This news of economic growth could ease fears of inflation and rising interest rates that are triggering the migration to value.
But Omicron is so contagious that it will likely go as quickly as it came. We see that in countries that are hit early, like South Africa and the UK. Then factors like stimulus, inventory building and strong consumer and corporate balance sheets will revive growth.
This would mean that the dichotomy between growth and value will continue this year – as three of the four main drivers of the trend are associated with strong growth.
Michael Brush is a columnist for MarketWatch. At the time of publication, he owned TSLA. Brush has proposed TSLA, C, FDX and GM in his stock newsletter "Brush Up on Stocks". Follow him on Twitter @mbrushstocks.