Executive Summary
A core concern for investors contemplating taking advantage of the incredible cheapness of deep value stocks today is the potential for a near-term recession. A common perception is that value stocks are more cyclical and therefore more vulnerable to economic downturn.
We find that this conventional wisdom is false: empirical evidence shows that value stocks actually tend to outperform in recessions. Value stocks have the charm of low expectations. No one is expecting all that much from them, so they have less to lose in an economic environment in which companies of all stripes wind up having a tough time.
Based on current valuations, deep value is priced to significantly outperform the rest of the market. Our analysis suggests that the prospect for deteriorating economic conditions in no way impairs this thesis.
Introduction
Perhaps the most common question we have been getting lately when expressing our enthusiasm for value stocks is “But isn’t value just dialing into recession risk?” Answering this question is a bit complicated by the fact that there is no single agreed upon valuation metric to define value stocks. At GMO, when we build a valuation metric, we first try to remove accounting distortions that make measures such as reported book value and earnings problematic. Our standard “pure” value model, called Composite Value, makes those adjustments but no others. For building strategies such as Equity Dislocation 1 and U.S. and International Opportunistic Value 2 (strategies we have created recently to take advantage of today’s market extremes), we use value models that make further adjustments for company quality and growth.
As a result, we have no single answer to the question, “How does value do in a recession?” But honestly, the nuances of different value models don’t matter much in answering that question, since pretty much every way of defining value has done just fine across most recessions. 3 The only recession in which value models did notably badly across the board was the Covid recession of 2020, and that event was so utterly unique that I’d argue it was a different sort of event entirely.
Certainly, the next recession – whenever it comes and however it transpires – is much more likely to look like one or other of the prior recessions of the past 50 years than the COVID crisis, a rare event that completely shut the economy for on-premises businesses (think value) while simultaneously launching online companies and enablers to the moon (think growth). So I believe it is more instructive to look at the performance of value across the range of recessions we’ve seen over the last half century.
We would not recommend building value portfolios on the basis of standard price/book or price/earnings ratios. But even if an investor insisted on doing so, on average they'd have done decently well across recessions of the last 55 years. In fact, every version of value besides price/book performed better in an average recession month (even including Covid) than in a non-recession month since the end of 1969!
That analysis is for broad value and today we have been arguing that among U.S. equities it is only deep value stocks that are really interestingly priced. One could imagine that the cheapest tail of the market dials more heavily into recession risk, but that simply isn’t the case, as we can see in Exhibit 2.
Once again, apart from Covid, there isn’t a particular pattern of trouble across recessions for deep value. Let me emphasize this point: despite the common narrative about value in economic downturns, there is simply no empirical evidence to suggest value stocks consistently underperform during recessions. The cheapest price/book stocks did have quite a rough time of it in the Global Financial Crisis, but for the lowest quality way to define value one can readily imagine, 4 one notably bad outcome across seven recessions is substantially better than one would have naively expected. For versions of value that pay more attention to quality considerations, there were simply no noteworthy negative performances for value in U.S. recessions other than during Covid.
For those of you less uniquely oriented towards the U.S. stock market and economy, the pattern is not particularly different in the rest of the world. Exhibit 3 shows the performance of the cheap half of the market in recessions for the four largest developed economies outside the U.S.
Continue reading with charts here.
