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Value stocks: Waiting for the comeback

Value stocks are trading at a record discount compared to growth stocks. It is therefore tempting to jump on them. According to our Group Chief Investment Officer, Yves Bonzon, it is however still to early for such a move.

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The end of a 11-year bull market
Since the bottom of the market in 2009, we experienced a very long bull market, which, like every bull market, has some leadership associated. This time around, the decade was characterised by a very significant outperformance from high-quality growth stocks. What few investors then realised was that these growth stocks had a very unusual characteristic. In previous cycles, typically, leading companies – the fastest-growing ones – consumed a lot of capital to support their growth. This time around, the market leaders were actually producing unprecedented amounts of free cash flow – cash flow in excess of their reinvestment needs. This free cash flow production is an extremely valuable characteristic in the stock market, but even more so when the recovery is rather modest and nominal GDP growth quite low. 

Markets reacted in record time
During recessions, when the economy contracts, capital hides in the most resilient companies. That movement of capital in the market towards the safest investment leads to a widening of the valuation differential between strong and weak companies – so the strongest trade at record valuations in comparison with the weakest. Typically, it takes a few months for a recession to be fully reflected in stock prices, so it is usually a process. In 2020, due to the exogenous nature of the recession triggered by the pandemic – or more precisely the government response to the pandemic by shutting down the economy – the pricing of the recession took place at unprecedented speed. Everything happened within three weeks as compared with six months during the financial crisis of 2007-2008. Today, the cheap stocks trade at record discounts relative to the strongest stocks of the most resilient companies. 

Too early for value stocks
From that point, what can we expect going forward? Because obviously, it is tempting to jump on value stocks given their record discount. Unfortunately, two factors have to be taken into consideration: Number one, the magnitude of the economic shock to the private sector due to the economic shutdown has triggered a huge loss of income, impacting very heavily the weakest balance sheets. So, bankruptcy risk is higher than in previous recessions. The second factor is the fact that for value companies, which are more cyclical businesses, to outperform and close some of the valuation gap that we observe at the moment, we need the world economy to be decisively reflated. As all work shows, unfortunately, the required fiscal and budget support – the government response on the fiscal side – has not been sufficient in many countries yet to ensure a smooth recovery of the global economy to anywhere near previous levels of activity. Therefore, value stocks will continue structurally to struggle until we reach the point at which the world economy is broadly and decisively reflated.