After the Darkest Hour Comes the Dawn

As economic activity in Europe begins to stabilize, we believe the rotation toward small value is just getting started.
 

By: Brian Chingono

In the fourth quarter of 2022, global markets rallied from their September 30 lows, led by international firms and small value stocks in particular. This rebound was driven by a recovery in cheap companies that had been oversold during the pessimism of the first nine months of 2022. According to MSCI and FTSE Russell, small value indices returned 23% in Europe, 13% in Japan, and 8% in the US during Q4—ahead of the market indexes in all three cases. But Europe was the only developed market where small value lagged the market for 2022 as a whole.

Figure 1: Small Value vs Market Returns in 2022

Source: MSCI and FTSE Russell

What explains the more extreme outcomes for small value in Europe during 2022 relative to other developed markets? Quite simply: fear and reaction to news. Small value stocks often sell off on fear and rally on results. The past year was no exception: Europe’s small value stocks bore the brunt of pessimism in 2022 and appear to be benefiting the most from news that economic fundamentals in Europe are turning out better than anticipated. In the summer of 2022, there were widespread fears of natural gas rationing across Europe during the winter. Instead, Europe entered the winter with full gas storage (albeit procured at higher cost), and now that winter is here, there are no signs of serious concern over gas rationing. In fact, natural gas prices have declined by 50% since the summer highs, with February gas futures trading at the same level as a year ago, before Russia’s invasion of Ukraine. Consequently, fears of a deep recession in Europe appear to be receding, with the ECB President Christine Lagarde reiterating in December that “the recession we feared is likely to be short-lived and shallow,” as she cited projections of 0.5% GDP growth in 2023 and 1.8% and 1.9% growth for 2024 and 2025 respectively. While every forecast should be taken with a grain of salt, we believe it’s important to note that the ECB’s base case appears to align with today’s moderate level of the credit market’s “fear gauge” since European high yield spreads ended the year at 5.0%, almost exactly in line with their long-term median level of 4.9%.

The signs of resilience in the underlying economy suggest that central banks may stay the course in keeping interest rates at higher levels to tame inflation. And we believe that would spell good news for value stocks that distribute cash to shareholders today, as opposed to growth stocks that offer payouts in the distant future. After a decade of record-low interest rates that were cited as a reason for paying almost any price for growth stocks (and stretching valuation spreads to near the 100th percentile of recorded history in 2021), today’s higher cost of capital means that expensive valuations are much harder to justify. And we believe value stocks, which trade at bargain multiples, should become more attractive to investors on a relative basis. We can see evidence of this dynamic in the chart below, which shows the rolling three-year difference in returns of value stocks versus growth stocks.

Based on the longest data sample we have available since the mid-1970s, we can see that up until the decade of near-zero interest rates began in 2008, bouts of underperformance in value relative to growth were followed by relatively long periods of outperformance in value. And after the bursting of the previous tech bubble in 2000, value’s outperformance was the strongest. So now that we appear to be returning to an interest rate regime where capital actually costs something, and there are clear signs of a contraction in the tech sector, we believe that value stocks could be on the cusp of a winning stretch similar to the 1980s, 1990s, or the 2000s.

Figure 2: Rolling 3-Year Value Premium in Europe (1975 – 2022)

Source: Ken French data library

Global valuation spreads have already begun to narrow from 2021’s record-setting levels to the 94th percentile at the end of 2022. As evidenced by the value-led rally in Q4, even a small amount of mean-reversion from extreme levels can move the needle in big way for value returns. We believe the recent recovery for small value is just the tip of the iceberg, and there is still a lot of room for value to run in the years ahead, from today’s extreme level of valuation spreads. Historically, wide divergences between the valuations of cheap stocks relative to expensive stocks have preceded significant outperformance for value over the subsequent decade, as shown in the figure below.

Figure 3: European Valuation Spreads (1975 – 2022)

Source: Ken French data library
Today, deep value companies in Europe can be purchased at around 5x EV/EBITDA and 0.8x Price/Book, based on data from S&P Capital IQ. If firms in that category prove to be more resilient than the pessimistic expectations embedded in their prices would imply, they could significantly benefit from multiple expansion over time and still avoid looking expensive. And while waiting for the fruits of mean reversion, we believe investors in European deep value companies can benefit from cash distributions in the form of dividend yields around 4%, share buybacks, and deleveraging.

Given the combination of attractive valuations and geopolitical uncertainties in Europe today, we believe there are two ways to maximize returns in Europe, depending on investors’ time horizon. For long-term capital, we think investors could benefit over the long haul by building European deep value exposure now, while credit markets are pricing in an average amount of risk, the economy is stabilizing, and valuation spreads are still at historically extreme levels. As global valuation spreads narrow from the 94th percentile toward average levels over the coming years, we believe there could be a winning decade for deep value on the horizon. And for European deep value in particular, we believe there is even more room to run over the long term since the value rotation witnessed in the US and Japan in 2022 is only just beginning in Europe.

For short- to medium-term capital, we believe investors could keep those amounts in reserve—perhaps in short-term corporate credit—and consider deploying that capital into European deep value if high yield spreads widen to 8% in the future. Our research suggests that one- and two-year forward returns are often maximized following that crisis threshold.