The tide continues to turn for value-growth dynamic

Following a prolonged period of challenging growth and exacerbated by strict COVID-19 restrictions, global economies have now begun to reopen in earnest. This has been associated with a material inflationary spike with CPI prints across major economies pushing to the strongest levels seen since the recovery from the GFC.

While the inflationary spike itself has been significant, importantly beneath the headline strength we are also now seeing a reconfiguration of the underlying drivers of inflation. A clear dynamic over the past decade has been that non-tradeable (services) inflation has been stronger than tradeable (goods) inflation.

This strong demand for services had meant that many growth-style companies were able to maintain quite healthy earnings while their input costs fell, supporting the outperformance over the typical value-style companies.

The recent inflationary spike that we have seen has reflected a swing back to tradeables inflation, with increasing goods and commodities prices helping to generate momentum behind the move. Increasing goods costs with relatively static input costs will help to create a beneficial environment for Value stocks such as resources companies and other goods producers, strengthening the tailwind for Value’s relative outperformance going forward. 

Australian inflation: tradable vs non-tradable

Economic factors create solid value backdrop

Value stocks have historically shown a strong performance correlation with strengthening economic growth and movements in bond yields. These factors have clearly provided a headwind for value in recent years, with pandemic-induced lockdowns driving a global economic slowdown and inciting an extreme monetary policy response from central banks.

As restrictions continue to be eased, measures of global growth, such as the world Purchasing Managers Index (PMI), are reflecting a rapid economic recovery, driving a material spike in inflation and raising expectations of monetary policy tightening through 2022. 

We believe that these conditions will provide a supportive backdrop for the continued outperformance of value stocks going forward.

The sharpness of the recovery from COVID-19 lockdowns around the globe has seen a significant spike in the world PMI, without an equivalent narrowing of value spreads. This enduring gap further highlights the significant opportunity that value exposures represent as the global economy continues to reopen. Value style stocks remain cheap relative to the broader market despite the period of outperformance through the year-to-date.

World PMI and the MCA Value Spread (inverted)

Rising yields have historically shown a strong correlation with positive Value style returns and a narrowing of the Value spread. Yields had been trending lower since the GFC as monetary policy settings were progressively loosened in an effort to spark growth. 

While central banks are naturally being quite cautious, monetary policy settings are beginning to normalise around the globe, and forecasts for major economies suggest that rates will continue to rise, which will push bond yields higher and should therefore provide a tailwind for relative value performance.

Relative performance of MSCI style indices and US bonds

Australia represents a compelling value opportunity 

The Australian equity market is notably value-tilted, with a large weighting to very high-quality financials, which will benefit from rising interest rates, and materials/resources, which will benefit from supply chain limitations/disruptions and growing momentum behind the global push toward net-zero.

Conversely, the US market is more leveraged to the tech-led growth thematic, with major technology stocks such as Apple and Amazon making up more than a quarter of the total market capitalisation of the S&P500 index and representing 8 of its top 10 constituents by weight.

Australian vs US sector weights

While there are of course value stock opportunities within the US market, the large concentration in growth-style names trading on significant multiples highlights the better positioning of the Australian market as an opportunity to capitalise on the rotation to Value.

We would note that thematic influences associated with these differences have already driven a clear performance dispersion between the two markets over the year to date, with Australia’s greater value-orientation supporting outperformance relative to the US and other global markets. With growing momentum behind the rotation back to value, we see a meaningful opportunity for this relative outperformance to continue. 

Index cumulative returns this year

The time for value is now

The economic tide is turning, and Australia presents a particularly compelling opportunity to capitalise on this trend given the market’s strong value orientation. Extremely high valuations across growth stocks have highlighted the degree of downside risk associated with these exposures, and while the performance reversion has already been sharp, there is notable scope for this to persist. 

Examples of our Select 'Value' Opportunities

Our stock selection, driven by our proprietary fundamental analysis process, is positioned to benefit from a continuation of the rotation to Value. Our Australian focus provides the opportunity to benefit from the geographic advantage within this thematic environment. 

Woodside Petroleum

Our overweight position in oil and gas producer Woodside Petroleum (ASX: WPL) was initiated in 2017 in response to oil prices trading below our view of long-term normal, which was not reflected in the market’s thinking. We have subsequently increased our overweight positioning reflecting the company’s exposure to the energy transition, expanding project pipeline, and upside associated with the merger with BHP's oil and gas business.

South32

We maintain a high conviction overweight allocation to South32 (ASX: S32), a diversified metals and mining company. The company offers attractive and well-diversified exposure to commodities such as aluminium, which we see as key for the energy transition push. We consider S32’s asset base to have high cash generation capacity which provides a material return opportunity for shareholders. The stock has been very strong in recent months, supported by broad commodity price strength, but on balance of the remaining opportunities we still see further upside for S32 going forward.

Worley

We have been expanding our overweight allocation to global engineering, advisory and project management services company Worley (ASX: WOR) since late 2020, given the company’s beneficial exposure to the capex required to achieve the energy transition to Net Zero emissions by 2050, as well as increasing capex in its traditional businesses of oil and gas, chemicals and resources.

Nine Entertainment

Although television networks have seen a significant decline in audience and advertising dollars, growth in new Broadcaster video on demand (BVOD) platforms has reversed audience and revenue declines. Nine Entertainment (ASX: NEC) are continuing to pivot their business in a way that will help the structural declines in the publishing business along with creating growth in digital subscriptions and advertising. We believe that the market is yet to fully value the shift from "old media" to growth business and the stabilisation of the more structurally challenged parts of the business.

ANZ

Australia and New Zealand Banking Group (ASX: ANZ) remains the best valued Australian bank with a solid cost-out story to evolve, and a favourable business banking skew. A mix of initial reinvestment and Board focus should ultimately see this management team deliver the cost savings needed to improve earnings. The business banking skew should see growth return in 2022 whilst bad and doubtful debts remain subdued. This is partly built into valuations, but we expect to see further upside for ANZ versus peers.

Medibank Private

We believe that the quality and earnings stability of Medibank Private (ASX: MPL), Australia’s largest health provider, together with growth opportunities from diversification and consolidation, are being undervalued. We expect MPL to outperform private health insurance industry peers due to its superior ability to manage costs and innovate, whilst finding new sources of growth as the company pursues a broader role in healthcare.

Vicinity Centres

Retail REITs were significantly sold down during the height of COVID-19 social restrictions; however, the retail sector has been bouncing back with tenant demand for leasing improving. Whilst Vicinity Centres (ASX: VCX) share price has started to recover, it is still trading well below pre-COVID levels and at a very large discount to Net Asset Value. As retail sales and foot traffic further recovers, we expect the discount to reduce over time. Recent asset transactions in the retail property sector further point to the valuation upside for VCX.

QBE

We initiated an overweight allocation to diversified global insurer QBE Insurance Group (ASX: QBE) in December 2021 reflecting a strong Valuation signal on the stock, which had notably underperformed global peers despite solid underwriting discipline and reserving practices. Recent company results have highlighted that the business recovery is well underway, which we believe will be supportive of expanding margins, driving upgrades to consensus and providing share price support.

Insignia 

Insignia (ASX: IFL) is a focused player in the financial intermediary space that operates a low-cost carrier model. IFL remains a turnaround story and doubled down on the synergy extraction via the MLC deal. Delivering on these cost savings is the key to the value opportunity, as this should more than offset core platform business decline from margin contraction and set the group up for the future of advice delivery. This creates greater execution risk, but also a larger prize and better industry structure that we believe is being under-estimated by the market.

Alumina

Alumina (ASX: AWC) is a leading Australian resource company and one of the world's largest, lowest cost alumina (the feedstock for aluminium smelting) producers through its joint venture with Alcoa. We see it as a high-quality company, with valuation support, and increasing margins as demand for Aluminium, and therefore Alumina, increases with global decarbonisation. The high alumina price currently reflects supply disruption from the Russia/Ukraine conflict, further enhancing AWC's near term earnings

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable

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The Martin Currie Select Opportunities Fund provides investors with a diversified exposure to our highest conviction stock ideas with Valuation potential, while balancing risks through our focus on Quality and Direction. Find out more by visiting our website.