Value Stocks Are Not Created Equal

By Garrick Hull

Some stocks are cheap for a reason. So how to differentiate true winners from value traps? The answer, in a word, is quality.

Stoked by macroeconomic uncertainty and heightened geopolitical tension, value-based equity strategies saw a resurgence in 2022. However, not all value strategies are created equal, and some stocks are cheap for a reason. So how to differentiate true winners from value traps?

We believe that process starts by better defining what a “value” stock truly is—and that means focusing hard on the quality of a company’s true financial performance.

While passive value indices are typically based on book yields, we incorporate a more diverse set of signals to sift for higher-quality targets. These signals include traditional measures—such as operating cash flow, dividend yield and earnings quality (which captures the degree to which aggressive accounting maneuvers cause net income to deviate from actual cash flow)—as well as other quality-focused markers like solvency and return-on-equality. Tracking this combination of signals, we believe, allows us to build more robust value portfolios with the potential to outperform throughout multiple business cycles.

Quality has always mattered, of course, but it especially matters in downturns when companies with more aggressive accounting tend to get stung worse than those with higher-quality earnings. Over the last 25 years, from 1997 to 2022, the MSCI USA Quality Index delivered an 8.6% annual return—160 bps annualized more than the MSCI USA Net Total Return Index. In the 2008 financial crisis, however, the quality index outperformed by a full 10%.¹

As we enter the latest downturn and stock valuations continue to reset, disciplined investors will likely find high-quality stocks available at attractive discounts. In our view, falling earnings estimates, slowing GDP growth and tighter monetary policy should create tailwinds for high-quality value strategies in 2023 and beyond.

¹Bloomberg

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