By general consent, 2022 has been a pretty rubbish year for investors. One of the most-widely-watched stock market indices, the S&P 500, lost a quarter of its value from the year’s highest point to its lowest. However, unless you have a very concentrated US-focused portfolio, that will almost certainly not have been your experience. I expect you lost money this year but rather less than Wall Street’s performance would suggest.
If you have a reasonably diversified portfolio, your overall return will reflect the performances of a mix of different assets and geographies. Your UK shares have held up much better, for example. Perhaps you had some gold, which has gone sideways. Bonds have not had a great year either, but they’ve been less volatile and lost less than US shares. Even within an individual stock market, 2022 has been a year of contrasting fortunes. This is well illustrated by the massive divergence between so-called growth and value shares.
The Russell 1000 Growth index, which holds more expensive shares that investors believe will grow their earnings faster than average, has fallen by about 25pc this year. The Russell 1000 Value index, which is full of cheap and out of favour shares, has by contrast only lost about 5pc. For anyone relatively new to investing this is a novel situation because ever since the financial crisis the reverse has been true. Led by the FAANGs and other technology stocks, growth had consistently, and massively, outperformed value for more than a decade until this year.
It is not unusual for one of these two styles to consistently outperform for an extended period of time. In fact, the past 35 or so years can be divided into just three multi-year trends. From the late 1980s until the dot.com boom and bust, growth led the way, as it did between 2008 and 2021. The eight years in the middle belonged to value. Despite this year’s outperformance by value, the cheapest shares are still unusually inexpensive when compared with the most highly priced. This is one of the reasons why some believe we may be at the start of another extended period of outperformance by value.
So, why should value do better?
One reason is simply that the backdrop is less favourable for the growth alternative. A key driver of the outperformance of growth shares since 2008 has been the extended period of very low interest rates. Investors use expected interest rates to calculate a present-day value for a company’s future earnings and cash flows. When that rate is low, the current value of future earnings streams is high, and vice versa. Higher interest rates today make future growth less valuable.
Another reason is heightened uncertainty. Growth may be more attractive to investors when the future is unclear, but it is also less predictable. And when there is less certainty, there is less incentive to take a risk. When shares are priced for perfection, as technology stocks were at the beginning of 2022, you only need to fall a little short of over-inflated expectations to come back to earth with a bump. When those expectations are very low, by contrast, anything short of catastrophe can seem like a fair result.
Value can clearly underperform for extended periods but over the long haul the numbers tell a different story. The outperformance may come in short and sharp bursts, but these can be so explosive that in aggregate value can reward investors. To see what the growth versus value question looked like before the unrepresentative decade or so of near zero interest rates, I dusted off an old study from James Montier’s excellent book Behavioural Investing.
His analysis looked at global stock markets from 1975 to 2004, so it was extensive and extended. And it came to some pretty clear conclusions. First, buying the 20pc of shares with the lowest valuations outperformed the more expensive quintiles regardless of what the actual earnings growth turned out to be in the subsequent 12 months. Second, while outperformance could be achieved by investing in the shares that did subsequently deliver high earnings growth, finding them ahead of time is very hard to do consistently. Third, and crucially given this second point, buying shares with lower growth expectations delivers better returns than investing in those with the higher expectations. It’s the difference between expectation and actual outcome that counts.
There are a number of possible reasons why value outperforms over time. We are lured by the siren call of growth and so are tempted to overpay for it when, in reality, it’s either hard to find or not actually delivered. We are over-confident in our ability to identify growth despite plenty of evidence to the contrary. By contrast, value investing is realistic about our limitations and our behavioural biases. It’s just less risky.
So, if this is the case, why are we not all value investors? Again, a string of potential reasons. First, loss aversion. Because value investing’s returns accrue in short bursts, its adherents must face many years in which they underperform or even lose money. That’s very hard to live with. Second, we are hard-wired to favour the short over the longer term. Value investing comes good over years or decades. Most of us don’t have the patience. Third, being contrarian is psychologically very difficult. You have to swim against the tide. Few investors can do this with persistence.
Ultimately, value investing runs counter to what makes us human. We make sense of the world through stories. A growth story is just more vivid and easier to relate to than a valuation argument, so we follow the path of least resistance. And finally, the biggest stumbling block to value investing is that it’s less fun. People don’t want to get rich slowly. They want to win big in Vegas. If that sounds like you, go and find a good value manager to invest your money. This might be their time.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
