While everyone’s chasing momentum, the smart money is shopping for deep-value stocks at a 4-decade discount

It has been a stellar year for the stock market, considering interest rates are at a two-decade high.

The S&P 500 is up by 18% so far this year. Tech-heavy growth stocks continue to lead the gains, and for good reason: AI and its transformative nature have consistently delivered outsized revenue growth with strong profit margins.

Their performance has made them the 21st-century definition of quality, says Dave Mazza, the CEO of Roundhill Investments. But on the flip side, it has pushed deep-value stocks that are significantly discounted out of favor, he noted.

Still, while many investors continue to chase the momentum, Wall Street’s smart money is shopping for the bargains that have been left behind.

“Value investors have become the butt of many jokes because they’ve suffered years, if not decades, of underperformance relative to growth managers,” Mazza said. “But whether it simply takes a reversion to the mean or the environment economically begins to favor a broadening, it becomes a more attractive time to enter the space.”

Mazza, whose firm has an ETF that tracks the Acquirers Deep Value Index, believes that interest rate cuts, which could be on the horizon, remain the catalyst for a broader market rotation.

And the timing might be just right: According to an August note, the legendary investor Jeremy Grantham’s investment firm, GMO, has pegged deep-value stocks in “screamingly” cheap territory.

The cohort of stocks has now hit a four-decade low, or the cheapest since 1980, said Catherine LeGraw, an asset allocator at GMO. She added that deep value, which is the cheapest 20% of stocks they track, typically trade at a 40% discount to the market but are now at a 53% discount. Turning this part of the market into the firm’s highest conviction bet for a long-term strategy.

Historically, when deep-value stocks have traded in ranges near this cheapness, they dramatically outperformed the market in a subsequent five-year period by 19% on an annualized basis, LeGraw noted.

“What’s so unusual and interesting about value today is how much cheaper they are than normal,” LeGraw said. “We do a lot of analysis looking at how unusual the market environment is today relative to history, and what we found is that value and deep value are trading in the bottom decile of their normal historical range.”

How to shop value

Don’t be fooled by the traditional markers of cheapness that tend to lean into low price-to-earnings multiples. Numbers don’t tell the full story. A low P/E stock could be worth much less because of slowing profitability. Meanwhile, a higher P/E may warrant an even bigger premium. For GMO, it’s about looking under the hood at a company’s operations to determine whether it’s consistently profitable, has a low debt load, good management behavior, and a solid growth potential.

There’s often this idea that momentum is only growth, but it’s really just whatever has been doing well, says Kevin Gordon, a senior investment strategist at Charles Schwab. And there are times when deep value merges with momentum, and the two become one. This merger often happens when sectors come back after being left behind due to weaker economic conditions, he noted.

Gordon noted that stocks are more likely to fall out of their traditional grouping in the post-pandemic era. So, if an investor is screening for value characteristics using metrics such as a low P/E ratio, high free cash flow yield, or high-interest coverage, they will more readily find stocks that meet the criteria in every sector, including tech and communication services.

For example, Alphabet and Meta, traditionally seen as growth stocks, now fall into GMO’s deep value basket.

Be wary of the classic value traps, says Mazza. These are companies with deteriorating fundamentals, perhaps because their business models are broken or their industries are under pressure. They will look cheap but have no signs of growth or their growth isn’t profitable, he noted.

If you’re going to go the ETF route, Gordon cautions against simply piling into any value-labeled fund. It’s important to know how they filter for value. Funds that use simplistic multiples may miss the mark. Instead, they should use several criteria. This is especially important in a higher interest rate environment that may remain elevated for some time, he added. He advises sticking to stocks with higher free cash flow yields and higher interest coverage ratios.

Finally, how aggressively the Federal Reserve cuts rates will also impact value’s performance in the coming year, Gordon noted. If the cutting is slow and gradual, it means the economy remains strong. In that case, value-oriented cyclicals like financials, energy, industrials, and materials can do well. Conversely, if the Fed cuts aggressively in response to recessionary fears, value-based cyclicals will likely underperform given potential economic weakness. The good news is, Gordon believes the former scenario is more likely this time around.