Value equities have faced years of tough sledding, outside a run of outperformance following “vaccine day” and the lift-off from zero rates. Broadly, this has left value stocks extraordinarily cheap relative to growth. 1 However, looking closer, the cheapest 20% of stocks – what we call “deep value” – trades unusually cheap today despite offering surprisingly attractive fundamentals.
We have commented on this phenomenon in the U.S., 2 and we see a similar dislocation in developed ex-U.S. equities. As of May 31, 2023, that group traded near its widest discount to the market over its history (4th percentile dating back to 1983).
We said cheap, not junk...
Investors should not rely solely on reported financials and index definitions of value to dial into this compelling opportunity, as we believe doing so could misjudge it. GMO recently launched the International Opportunistic Value Strategy, which uses proprietary valuation models to select a portfolio of international deep value stocks. At the end of May, this portfolio was priced at significant discounts to the market and was also cheap relative to broad value, trading 15-25% cheaper than MSCI World ex-U.S. Value across valuation metrics.
Importantly, leaning cheap does not mean leaning into junk. Our portfolio has higher-quality characteristics than the broad value index, with less leverage (0.6x versus 0.8x debt/equity) and 10% higher ROE. The P/E and ROE measures in Exhibit 1 exemplify how we can build a cheap but relatively high-quality portfolio in international deep value.
...And not a trap
It may be natural for investors to question if this group is cheap for a reason or if it is more prone to recession risk than other equities. 3 We do not believe international deep value is a value trap first and foremost because of the quality and profitability of this group today. Its consistently strong fundamentals over time gives us further confidence that the cohort is unlikely to deliver a major fundamental disappointment.
International deep value equities have historically delivered stronger relative fundamental returns than “shallow value” (the remaining 30% of the broad value half of the market) in both good times and bad. To illustrate, in Exhibit 2 we examine two recent periods: value winning (August 2020-April 2023) and value losing (December 2017-July 2020). We decompose the relative performance of international shallow and deep value into returns from valuation (blue) and returns from fundamental drivers (orange). Valuation returns stem from changes in the price investors are willing to pay (i.e., relative multiple expansion or contraction). Fundamental returns are the combination of growth, 4 income, and rebalancing (the effect of companies entering and leaving each universe). Deep value companies do “undergrow” shallow value (and of course the market), but they more than make up for it by consistently providing higher income and rebalancing returns.
It may be natural for investors to question if this group is cheap for a reason or if it is more prone to recession risk than other equities. 3 We do not believe international deep value is a value trap first and foremost because of the quality and profitability of this group today. Its consistently strong fundamentals over time gives us further confidence that the cohort is unlikely to deliver a major fundamental disappointment.
International deep value equities have historically delivered stronger relative fundamental returns than “shallow value” (the remaining 30% of the broad value half of the market) in both good times and bad. To illustrate, in Exhibit 2 we examine two recent periods: value winning (August 2020-April 2023) and value losing (December 2017-July 2020). We decompose the relative performance of international shallow and deep value into returns from valuation (blue) and returns from fundamental drivers (orange). Valuation returns stem from changes in the price investors are willing to pay (i.e., relative multiple expansion or contraction). Fundamental returns are the combination of growth, 4 income, and rebalancing (the effect of companies entering and leaving each universe). Deep value companies do “undergrow” shallow value (and of course the market), but they more than make up for it by consistently providing higher income and rebalancing returns.
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