During the first three quarters of 2020, large caps outperformed small caps, and growth outperformed value—in a big way. The performance gap between large growth and small value was extraordinary, as was the case over much of the last decade. The cause of the divergence appears to be investors’ preference for less economically sensitive companies and those with promising growth prospects, without regard for valuation. Record low interest rates in the period buoyed equities but benefited growth stocks disproportionately.
Since September of 2020, we have observed a major performance reversal, with small caps and value stocks outperforming large caps and growth stocks. Positive news on the pandemic, most notably vaccine approvals and distribution, triggered optimism about an economic reopening. This has benefited cyclically exposed value stocks. More importantly, many deeply discounted stocks that had been priced at near distressed levels have performed exceedingly well. We had outsized exposure to such stocks but only those that had the balance sheets and business models to endure a prolonged economic slowdown—this exposure has been a welcomed tailwind in the value recovery.
Despite value coming back into vogue recently, the valuation gap between growth and value remains wide because the starting point was so extreme. At the end of September 2020, the gap between small value and small growth was almost at an all-time wide. During value’s recent outperformance, the valuation gap moved from the 1st percentile to the 14th percentile. Accordingly, we believe value has longer to run. A continued reversion toward more normal/average valuation relationships could provide a powerful and enduring value tailwind.