Positioning for a Resilient Value Cycle

Markets oscillate between favoring growth stocks and value stocks. Though growth stocks have had a long run and are outperforming value stocks so far this year, several macroeconomic and market fundamentals support the view that we may be at the start of a resurgent value cycle. “We’re entering a new environment that is good for value investing,” said Sam Peters, managing director and portfolio manager at ClearBridge Investments. 

Looking at the current market, “the growth indexes have exceeded value indexes by over 20%. The value of value is in the 99th percentile relative to growth, as measured by U.S. large cap value spreads. But that’s only been true 1% of the time in U.S. market history,” said Peters, who co-manages ClearBridge’s Value Equity and All Cap Value Strategies. The current market returns have been concentrated in a handful of growth stocks, many of them technology related. Yet several of these companies, for example Tesla, have very high valuations but weak fundamentals, he noted. “At some point, that valuation edifice is going to be vulnerable. A new market cycle favors value.” 

^{Source: ClearBridge Investments}

Structural issues
The shift to a market cycle that favors value over growth stems from fiscal spending as opposed to monetary policy, the higher-rate environment and the energy transition. The unprecedented fiscal deficits following COVID are raising the cost of capital for all borrowers. In contrast, during the easy-money environment of lax monetary policy since the global financial crisis, every business model appeared to be successful, which created positive conditions for growth stocks. That “was a terrible environment for value. Valuation was perverse and value completely sidelined,” Peters said.

Today the higher cost of capital as well as higher inflation and volatility favor value going forward. “Value is the style that is much more resilient in this environment,” he said, noting that investors may be underreacting to the current era of fiscal deficits and higher interest rates.

The standard forecasting models in use may no longer be accurate because they tend to still assume underlying drivers from monetary policy rather than from fiscal policy, he said. “After a decade-plus of free money and central bank dominance, fiscal policy is dominant now.” 

ClearBridge is focused on value stocks that will benefit from higher energy prices and higher interest rates. In addition, it aims to deliver the diversification away from a concentrated market index that asset owners are looking for. “You are able to find attractive stocks with strong fundamentals if you go outside the index,” Peters said. “By being an active value manager, you can provide index insurance — but unlike most insurance, it costs you no money.”

Given how dislocated value stocks are today, relative to the S&P 500 index, investors face a compelling moment to embrace value. “Our job is to be an active manager offering differentiated returns. Everybody has the growth trade on, with vast amounts of money and record levels of concentrated capital. There’s an opportunity to diversify from that and be active, and a value strategy should be on the menu.”

Favorable scenarios
Investors are increasingly skeptical about the prospects of the Fed achieving a soft landing, but regardless of the outcome, the macro environment through 2024 is likely to increasingly favor value, Peters said. “We are back to an environment where money costs something, and you have to pay attention to valuation. That’s powerful for value.”  

If a recession were to occur, many value stocks could prove to be resilient because of their strong balance sheets and high cash flows, he said. “Most of our portfolio stocks are already discounting a recession, and if we have one, the potential for value will be even greater.”

Under the scenario of no recession, value stocks could still outperform because of the higher cost of capital, Peters said. “Better fundamentals are going to matter. The proposition for value is too attractive to ignore regardless of whether we get a recession or growth.”

While a Fed pause on raising interest rates or even lowering rates in the future is a possibility, Peters noted, concerns about a higher-for-longer rate environment has led to overreaction in some market segments including regulated utilities and other defensive areas. According to Peters, some of these stock prices have fallen below business value — and that has created opportunities for value managers. “It’s not everywhere, you have to stock pick using a valuation discipline,” Peters said.

The value discipline
ClearBridge’s value portfolios are designed to be resilient across many different scenarios, not just a single one, Peters said. “As value investors, we try to buy as many possible future scenarios at reasonable valuations. We want a portfolio that’s safe not only from our own [potentially incorrect] forecasts, but also everyone else’s. The key questions are: What is resilient across any given market and economic environment? And where are we getting paid the most to take the least risk?”

This new, more ‘normal’ economic environment of higher interest rates is one that has been marked by crises, such as the liability-driven investing strategy meltdown in the U.K. and the pullback from regional banking in the U.S. “We try to be resilient to this new environment and uncertainty. We use low embedded expectations, where our stocks — even if they may have somewhat bad outcomes but a less poor outcome than the market expects — can do very well,” Peters said. “That’s the value discipline.”  

Energy transition
The ClearBridge Value Equity Strategy’s largest overweight sector, relative to the Russell 1000 Value Index, is energy. Energy companies present an attractive profile for several reasons, including positive cash flows and strong balance sheets. “In this rising cost-of-capital environment, we look for companies with free cash flow, ‘fortress’ balance sheets and pricing power. We want companies that have no external financing needs and can actually return capital to shareholders,” Peters said.

Several energy companies have used cash flows to pay down debt and offer among the highest dividend yields in the market, yet this is not fully reflected in their market price. “Energy has the second-highest returns on capital after technology, yet despite these positive fundamentals, energy stocks are significantly cheaper,” he added. 

Energy companies “can also be a good answer to geopolitical risks,” Peters said. As the world’s energy supply is relatively inelastic, with trillions of dollars still underinvested in light of ongoing demand, the sector is in a favorable long-term cycle, he said. It is also bolstered by the global clean energy transition, which offers several opportunities to value investors, given unprecedented sums being spent on nontraditional technologies.

“Energy will be supported by fundamentals, high free cash flows and returns to capital, with much of that free cash flow coming back to shareholders. As a value investor, that is exactly what we are looking for,” he said. “And yet, many energy stocks are the cheapest they’ve ever been” — presenting an opportunity for active value managers who have been able to identify mispriced energy companies.

Power of AI
Artificial intelligence will power the next growth cycle, Peters said, but it could also prove to be disruptive to past winners, such as growth stocks. “Not all of those business models will emerge unscathed. They’re not all going to be winners in an AI environment.”

Instead, AI could be helpful to value stocks. “It’s a powerful tool to drive better returns and productivity, and a lot of those economic rents are going to be captured by value companies,” Peters said. Examples of how value stocks could profit include energy companies that use AI to model oil fields or insurance companies that use AI to better underwrite risk.

Absolute-return target
Active management in value investing is key to achieving higher returns, market diversification and reduced portfolio risks, Peters said. “We have an absolute-return value discipline where we try to generate a low double-digit return across the market cycle.” 

In terms of risk mitigation, he said, “you need to avoid permanent loss of capital, and then to control volatility at the portfolio level.” The Value Equity investment process is designed with that in mind. 

“Most people want to buy low-volatility stocks, and they’ll typically overpay for that,” Peters pointed out. But “what is most depressed in price now are high-volatility value stocks.” While such stocks might appear to be inherently risky, ClearBridge’s active approach is able to manage such risks. “We find mispriced high-volatility stocks that have low correlation to each other. When we put those together at the portfolio level, it smooths the ride, resulting in better risk-adjusted returns,” he said.

Active management is also critical for achieving diversification from standard indexes, such as the S&P 500, Peters said. ClearBridge’s Value Equity Strategy has a 90% active share, Peters said, versus the market benchmark. “We look for mispriced stocks with great fundamentals. As the standard indexes have become more concentrated, that provides tremendous opportunities for an active manager. Right now you can buy strong fundamentals of companies offering double-digit free cash flows, and without balance-sheet risk, at incredible values.” 

Avoid the obvious
Underpinning Peters’ analysis is a focus on behavioral economics that can help identify departures from market efficiency caused by investor overreaction or underreaction to market news. “With higher rates right now, you get overreaction where the price falls too far, because people hate losing money and downside volatility. When the price falls too far versus value, we are able to exploit that,” he said.

Conversely, investor underreaction occurs when the market does not properly react to new information. A current instance is the markets’ underreaction to the growing fiscal debt burden in the U.S. “We exploit underreactions to change, and that’s very present in this environment,” he said.

Another key aspect of ClearBridge’s active investment process is that it is designed to avoid value traps — a situation where a stock is undervalued but its price doesn’t rise over time, often because of weakening earnings or other characteristics.  

“To manage these traps, we use falsifiable investment cases,” Peters explained. “We lay out why a stock is mispriced and why we think the market is getting something wrong. We use these investment cases to ask, Are those fundamentals going to lead to better growth?” If the answer is no, then it’s likely to be a value trap that warrants selling the stock, he said. 

“The key is systematically putting a provision into your process where you can change your mind when you are wrong,” Peters said. Historically, above 50% of the value team’s stock picks have outperformed — while the rest have fared differently. “Driving that double-digit return is the discipline of getting out of the way when you’re wrong.”

Cyclical trends
Peters’ use of Bayesian statistics, which involves assigning probabilities as facts or parameters change, is a core part of the team’s risk-management process. “I’m a Bayesian statistician. It’s how you systematically change your mind. The key to that is being intellectually honest. In our process of avoiding value traps, everything is falsifiable. We’re a differentiated valuation investor that uses our process to drive [positive] returns across the cycle.”

For any value investor, character is an integral part of their investment process — and Peters points to his curiosity, honesty and willingness to challenge and update his own prior beliefs. As a value investor “you have to play a lonely game, to apply math and rigor and to realize everything is cyclical.” 

Peters’ background has helped inform his point of view. He grew up in a New Mexico ranching family, experiencing first-hand the economic cycles in agriculture, oil and gas. His independently minded grandmother offered foundational wisdom: “She would tell me, If you extend the lens of time long enough, everything’s ultimately cyclical.” 

The insight persists today in ClearBridge’s Value Equity Strategy, which constantly questions, “Where can we get the future as cheaply as possible? Where can we get free options on randomness? That mindset of everything being cyclical and then exploiting it through a value lens has been formative,” he said. ■

^{Past performance is no guarantee of future results. Copyright© 2023 ClearBridge Investments. 
All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.
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