Will value stocks continue to outperform expensive sector peers?

Value stocks have strongly outperformed their growth sector peers since late 2020, when they became as cheap as they were at the peak of the 2000 tech bubble. Although half of that advantage in valuations is now gone, we believe it still leaves plenty of room for an above-average performance by value stocks, especially when interest rates are rising in developed markets.

Value stocks typically trade cheaply relative to their fundamental values. In early 2021, in Value investing: Is this the biggest opportunity since the tech bubble?, we showed that value had become as cheap relative to their macro-sector peers[1] as it was at the top of the 2000 tech bubble.

This was illustrated by plotting the value spread – that is the difference between value stock valuations and those of their most expensive macro-sector peers, which are typically stocks with higher expected earnings growth, irrespective of their sector.

Since then, value stocks have strongly outperformed. We believe it is now worth checking out how far such outperformance has compressed the value spread.

Value spreads in macro-sectors have narrowed by 50%

Exhibit 1 shows an update of the composite macro-sector neutral value spread for stocks in the MSCI World index using the same approach as in our early 2021 publication.

The value spread for these stocks has now compressed by about 50% since the peak in late 2020. We find a similar pattern in the US and in Europe (not shown).

Exhibit 1: Normalised composite value spread for stocks in the MSCI World universe

Note: normalised composite value spread since 2000 and a reconstruction of the universe back to end 1995; sector neutral based on five macro-sector definitions; a diversified set of value factors described in our article was used to measure the valuations; source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.

What does this mean for outperformance in each macro-sector?

On average, value stocks in each macro-sector tend to outperform their most expensive peers. This excess tends to be above average when the value spread is compressing, as has been the case since late 2020.

When the value spread moves only slightly, value stocks tend to generate an average level of outperformance. It is only when the value spread expands rapidly and strongly that value stocks have a higher probability of underperforming their peers. This was the case from mid-2018 to late 2020 and in the tech bubble between 1998 and 2000.

Moreover, as we explain in our article, a typical catalyst that can start to expand the value spread is an increase in the difference between the expected earnings growth of value stocks and that of the most expensive stocks, as happened from mid-2018 through late 2020.

With interest rates now rising and expected to rise further, it is unlikely that an increase in that difference will now cause a widening of value spreads.

With that in mind, and given that value spreads are still relatively wide, we foresee an above-average outperformance of value stocks relative to their most expensive peers in each macro-sector as the most likely scenario in the medium term.

Finally, if value spread compression overshoots, as it did between 2000 and 2006, we could see several years of above-average outperformance of value stocks.