One of the big financial market themes of 2022 was the renaissance of value investing, after a stretch so bad and so long that quants had to scour the history books for parallels.
Think this, but for years:
Things changed radically in 2022. The divergent performance of Clifford Asness’s AQR Capital Management and Chase Coleman’s Tiger Global offers a great snapshot of how value and growth stocks did last year.
Value-loving AQR’s Absolute Return fund returned 43.5 per cent net of fees last year, its best performance since its birth in 1998, while the Tiger’s growth jockeys lost 54 per cent up to the end of November (we’re still waiting to hear the final toll, but it will probably end up being one of the biggest hedge fund losses in history).
Asness obviously reckons that value is still cheap and the growth bubble has much further to deflate. And in a world where SpaceX can still raise money at a $137bn valuation it’s hard to disagree.
But GMO, the value-oriented investment house founded by Jeremy Grantham, thinks that the next leg of the resurgence will come from “deep value” stocks — reeeeeaally cheap companies, as opposed to just modestly-priced ones.
Here is the latest update from GMO’s asset allocation team, led by Ben Inker, on what they reckon is the “hidden gem” of financial markets today:
Investment committees around the world will soon meet to assess 2022 portfolio performance, often looking line by line at winners and losers. However, we believe the most attractive group of U.S. stocks today is one that is likely absent from most existing portfolios, or at least woefully under-represented — the cheapest quintile or “Deep” Value.
After the longest cycle in which Growth massively outperformed Value, many portfolios dropped their underperforming Value managers or hung on to those that leaned a bit less into Value to survive. No exposure means no line item, which means most committee members and staff may not be thinking about Deep Value.
That “deep value” has lagged the value renaissance is actually unusual. As GMO points out, value runs like those we saw in 2022 tend to be driven by the cheapest stocks rather than what GMO terms “shallow value” stocks.
While Value outperformed Growth by a wide margin last year, 2022 marked an aberration in the relative performance of Deep vs. Shallow Value (the next 30% of cheapest stocks after Deep Value). Deep Value usually outperforms Shallow Value when Value outperforms; not so in 2022.
You can see how exceptional 2022 was in this chart:
As a result, deep value stocks are exceptionally cheap both relative to their own history and that of the broader market.
GMO estimates that if all quintiles of the US stock market revert to their historical median valuation then deep value stocks will outperform the rest of the market by about 30 per cent.
We’re unconvinced. GMO concedes that the likelihood of a reversion to median historical valuations is a strong assumption, but they seem to be missing the wood for the trees: deep value stocks are deep value for a reason.
The reason deep value tends to lead value stock recoveries is because value stock recoveries tend to coincide with countries emerging from recessions. The cheapest companies are the weakest companies and often priced for the possibility of bankruptcies. They therefore benefit disproportionately from an economic turnround, both in terms of buoyant earnings and a stock market re-rating.
The current picture is very different. While economic growth has been unexpectedly resilient we are clearly heading into a sharp slowdown in 2023, and possibly a recession. Is that the kind of environment where you want to own (basically) trash?
So while there might well be money to be made in deep value, it feels a bit like a big fat bet on a soft landing.
