In 2022, we had a positive opinion and tilted towards the value/dividend factor among equity holdings in our multi-asset model portfolios and, subsequently, a rather negative opinion on the growth factor. That worked out really, really well, adding a good amount of alpha compared to peers. But then, in late 2022 and so far into 2023, the growth factor has returned to dominance. While we have kept up with our peer group thanks to some other contributors such as Japan, an overall overweight in international equity and manager selection within fixed income, our style tilt has been, well, wrong so far in 2023.
A Postmortem is what it sounds like, except there is no dead body, and instead, it is your portfolio on the slab. It is an exploratory process to dive deep into previous portfolio decisions, now with the benefit of hindsight into what happened in the markets and the performance of the portfolio. In this case, what drove our value/dividend tilt in 2022 proved correct. And why didn’t we pivot back to more growth so far in 2023? The objective is to learn from both past mistakes and correct decisions to aid in future decision-making.
We hope you find this insightful, not just for your portfolio process, but for diving into any past decisions, whether they be investing, personal or business.
“We do not learn from experience….we learn from reflecting on experience.”– John Dewey
Why we were negative on the growth factor in 2022
Tilting away from growth and more towards value/dividends worked out smashingly in 2022. Almost all the stars were aligned in favour of value over growth at the start of that year. Measuring various equity style indices, growth really outperformed value in the 2010s, and this accelerated in 2020/21 with the pandemic induces spending patterns. At the start of 2022, growth indices experienced about double the performance of comparable value indices during the past three years. So let’s say the performance was certainly stretched.
This was confirmed in valuations. To say the valuations of growth indices were stretched at the beginning of 2022 would be an understatement. The average PE ratio across the S&P 500 Growth, Russell Growth and Bloomberg Global Growth sat at 33x. The average index percentile ranking based on their historical valuations was 95th – really close to the top. This was similar across other metrics, including price-to-book and price-to-sales.
Value factor index valuations were not cheap based on their respective histories, as the markets, in general, were more expensive. But they were nowhere near as stretched as you can see in the chart below.
There is a long historical relationship between earnings growth and relative style performance. Generally, when earnings growth is strong, value outperforms growth. Few intuitive factors behind this; earnings growth is more abundant when the economy is doing well. And the value factor has a greater representation in many economically sensitive sectors. Meanwhile, when earnings growth is scarce, growth tends to do better. This is also a scarcity issue because when growth is hard to find, those companies that can still grow often fetch a premium.
So at the beginning of 2022, what did earnings look like? Earnings growth looked pretty good. For the S&P 500, estimates sat at $209 for 2021, growing to $223 in 2022 and $241 in 2023. Solid high single-digit growth. This favoured value over growth.
When yields rise, as measured by the 10-year U.S. Treasury yield, value tends to outperform growth, and vice versa. This is driven by a couple of factors. Higher yields are more common when economic growth is accelerating, which makes earnings growth more abundant to favour value. Plus, growth companies tend to be viewed as longer duration based on future cash flows that are often much further in the future compared to value companies. Lower yields make the present value of those more distant cash flows worth more, favouring growth.
So at the beginning of 2022, yields had started to come off the troughs caused by the pandemic and subsequent monetary stimulus. But the path was clearly higher in 2022, which favoured value.
Putting this all together, performance, relative valuations, earnings growth and the trajectory of yields all favoured value over growth as 2022 got going. A value tilt was clearly an easy decision and the right decision.
But then something changed in 2023
Value’s outperformance in 2022 has certainly reversed in 2023 so far. So how did the above metrics stack up on January 1st of this year? Perhaps the strong run by value was due for a reversal, simply given the magnitude of the move. But other factors also lined up better for growth or at least much less of a headwind.
Based on the S&P 500 style indices, the valuation spread between value and growth, which was at historic extremes at the beginning of 2022, had narrowed considerably. In January 2022, growth traded with a 10-point premium to value. A year later, in January of ’23, this had narrowed to less than a 2-point premium. Growth has traded on occasion with a lower valuation than Value but very rarely. So safe to say a mere 2-point premium for growth was a check mark favouring growth over value [see previous chart on style valuations above].
Earnings growth, which was abundant in 2022, gradually declined. Recall there was high single-digit earnings growth in January 2022, 7% earnings growth forecast for the coming year compared to the previous. As estimates declined during the year, earnings growth expectations did as well, down to 2% earning growth in January 2023. Once again, this lower earnings growth environment favoured growth over value.
It doesn’t seem to be the absolute level of yields that matters; it is the change in yields that seems to correlate most with relative equity-style performance. 2022 saw yields rise materially, from 1.5% to 3.9%. This was good for value. So far in 2023, yields have moved around a bit but have been largely stable, sitting at 3.8% today. This may not favour growth, but it clearly isn’t the headwind compared to 2022.
At the onset of 2023, it may not have been a slam dunk that growth would outperform value, but it was a materially better environment for growth compared to the previous year.
Whoops, we should have clearly pivoted back to Growth from Value at the beginning of 2023, hindsight being 20/20 and all. Maybe it was the overconfidence that was fed by being so well positioned in 2022 had us believe there was more room to run for value. Regardless, the setup in early 2023 clearly favoured growth or at least a more neutral style stance.
This, of course, raises the more important question, what about the second half of 2023 and beyond? In the table below, we have summarized our signals/methodologies for style tilts, including the readings in January 2022, 2023 and in July 2023.
We would not chase this growth performance run as too many of the signals are now favouring value once again. The lesson of this postmortem is to really develop and trust your process and don’t be afraid to pivot. If you sit on a great trade for too long, it can become less of a good trade.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
Sources: Charts are sourced to Bloomberg L. P.
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