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Narrow Leadership Creates Opportunity
The US equity market’s narrow leadership in 2023 is well chronicled, but it’s nearly impossible to overstate. The “Magnificent Seven”, as the largest seven US stocks have been dubbed, have dominated YTD equity returns—contributing, in effect, 100% of the S&P 500 Index’s total return (through October).
These seven stocks have returned on average 84%, compared to -3% for the “S&P 493”, and more than half of S&P 500 stocks have generated negative returns. In fact, the equal-weight S&P 500® Index is lagging the market-cap weighted S&P 500 by the most since 1998 as the S&P 500 Index is up over 10%, while the equal-weighted S&P 500 was down ~2% through October.
Exhibit 1: S&P 500® Index vs Equal-Weight S&P 500® Index - Total Return Difference
We get it. Markets narrow when investors are nervous. Quality and stability are prized. Earnings growth has slowed in recent quarters, and ever since the Federal Reserve began its tightening campaign in 2022, markets have been on recession watch.
However, as value investors who have lived through multiple market cycles, we know from these experiences that when the pendulum swings too far in one direction, there are usually opportunities in the other direction.
The Opportunity Today
We specifically like mid-cap stocks. Mid-caps retain some of the appealing characteristics of the largest companies, typically having stronger competitive positions, greater diversification by products, business lines and geographies, and more seasoned managements. However, compared to the largest companies, they frequently have better growth prospects, greater takeover potential, and because they are less followed by Wall Street, may present greater opportunity for stock pickers.
Today’s relative valuations are compelling. Mid-cap stocks haven’t been this cheap on a relative basis since coming out of the tech bubble in the early 2000s (Exhibit 2). On average, mid-cap stocks trade at a small premium to large-cap stocks due to their faster growth rates, however today they sell at a discount of more than three multiple points. The Russell Midcap® Index sells for 15.8X vs 19.0X for the Russell 1000® Index based on next year’s estimated earnings.
Exhibit 2: Relative 1YR Fwd P/E: Russell Midcap® Index - Russell 1000® Index
Value Is (Still) Cheap
Within the mid-cap space, valuations are particularly attractive for value stocks. Aside from the pandemic years of 2020 to 2021, value hasn’t been this cheap relative to growth since the aftermath of the tech bubble. The Russell Midcap® Value Index trades for 13.8X FY1 estimated earnings. The Russell Midcap® Growth Index trades for 24.8X FY1 estimates. The average and median valuation spreads between these indices have been 9.6 and 6.5 percentage points over the past 25 years. Today, it’s 11.1 percentage points (Exhibit 3).
Exhibit 3: Relative 1YR Fwd P/E: Russell Midcap® Growth Index - Russell Midcap® Value Index
The valuation spread remains wide despite mid-cap value closing the gap significantly over the past three years. Through October, the Russell Midcap® Value Index’s 3-year annualized return of 8.8% was 8 percentage points higher than the Russell Midcap® Growth Index’s 0.8% return. This was driven by the extended starting valuations of growth stocks and the influence of rising interest rates. This is a big shift, but history has shown these value/growth cycles can persist for several years.
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