Is a new golden age of value coming?
Value stocks have outperformed for the last 12 months, or even longer and value investors are finally getting optimistic again. After a decade when seemingly only momentum strategies would work, are we heading into a new golden age for value investing?
Whether value will continue to perform strongly in the future will depend, in my opinion, to no small part on the future path of inflation. Rising inflation and the cost-of-living crisis have lifted energy stocks as well as banks and hurt growth stocks. Going forward, I still expect inflation to decline quite substantially for the rest of this year and in 2023, but there is a serious risk that inflation may become entrenched and remain at very high levels for many years.
It certainly is prudent to prepare for different scenarios, and I want to do that here. I downloaded the US factor returns for small cap, value, momentum, and quality stocks from Ken French’s database going back to 1927. Ken French also provides international data, but that typically starts only in 1990 so it isn’t really helpful if you want to check how stocks perform in a 1970s-style inflationary environment.
The table below shows the average annualised outperformance of the different factors for different levels of inflation. The market risks premium is defined as the return of the US equity market vs. the risk-free asset (i.e. the 1M T-Bill). As long as inflation stays below 4%, equity markets are doing fine, and the risk premium is large. But as we have learned once again in 2022, once inflation creeps above 4% or so, market returns break down quickly as companies struggle to deal with the cost pressures and investors are discounting future cash flows at increasingly higher discount rates.
The value factor, meanwhile, tends to do quite well for very high inflation rates. Throughout the 1970s, value stocks performed well vs growth stocks, but even at more moderate levels of inflation around 2% to 4%, value tends to do alright. It is only once we enter very low inflation periods or deflationary periods that value tends to lose performance.
Low inflation rates (though not deflation) benefit the momentum factor. In an environment of 0% to 2% inflation like we have seen during much of the last decade, momentum does really well, while value struggles. Note that for very high inflation rates above 6% both value and momentum have essentially the same performance again as very few companies can prosper in such an environment and momentum portfolios eventually home in on these companies, most of which tend to be value.
Factor performance depending on the level of inflation
Source: Liberum, Ken French Database.
But the level of inflation is only one part of the story. The direction of travel matters just as much. In the table below I have calculated the factor returns for different changes in inflation, comparing the inflation level at one point with that of the same date in the previous year.
Factor performance depending on the annual change in inflation
Source: Liberum, Ken French Database.
Here, we see that value stocks tend to do well when inflation is rising and the faster inflation rises, the better value stocks perform. However, if inflation declines, value tends to do less well. For a moderate decline in inflation, value stocks have a rather low premium. Only if inflation drops sharply do we see a large value premium. This is mostly a result of inflation dropping sharply in the depths of a recession when value stocks tend to perform well. Momentum, meanwhile, needs stable inflation to perform well. Declining inflation or quickly rising inflation is not great for this style.
What do we learn from this? Simple. As long as inflation remains high and ideally steadily climbing, like in the 1970s, value stocks are the best investment. But if inflation peaks and then declines again, momentum should make a comeback. With my expectation of inflation normalising in the next 12 to 24 months, I would not bet on a continued outperformance of value stocks, but strange as it may sound, I have been wrong on inflation before. And if I am wrong again, value stocks would be the investment to make.