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Those fears hit home last week when the U.S. Consumer Price Index report showed that inflation surged higher again last month, up 7% from a year ago. That’s the biggest increase in prices in 40 years.
The threat of inflation and higher interest rates also helped trigger a subtle shift in which type of stocks are performing best.
For the past several years, growth stocks, led mainly by technology, beat the market handily. But last year, value stocks jumped into the driver’s seat as the new stock market leaders.
And this shift may be just the beginning of a longer-term, profitable market trend. You should pay close attention to it.
Investors began rotating out of expensive growth stocks last year, as you can see above, and into more reasonably priced value stocks. And so far this year, this rotation from growth to value has accelerated even more.
In fact, since just Dec. 1, the S&P 500 Pure Value Index ETF (RPV) is up 12.6%, while its sibling the S&P 500 Pure Growth Index ETF (RPG) has taken a beating, down nearly 8%!
Historically, there are very good reasons to believe that this shift in favor of value will remain in place for some time. The gap may get much wider. And it has everything to do with interest rates and inflation.
In the past, during periods when the Federal Reserve was raising interest rates, value stocks have outperformed just about every other style of investment, according to Bank of America Global Research.
According to the research, during those periods when the Fed was hiking rates, triggering higher market volatility in the process, value stocks outperformed the S&P 500 by more than 7% annually.
Value stocks typically outperform as rates move higher because they are less expensive compared to the market, and especially compared to growth stocks.
It goes back to the proverb “a bird in the hand is worth two in the bush.” In this case, a dollar in profits today is worth more than the promise of a dollar in profits delivered tomorrow… or many years from now.
It’s all about the time value of money. When interest rates are low, a dollar’s worth of growth-stock profits earned years from now may be worth waiting patiently for.
But as interest rates rise, as they’re bound to do this year, future profits get discounted by higher interest rates. So those future profits are not worth as much to investors. That’s why investors turn to more reliable, current profits delivered by inexpensive value stocks.
But how do you define a value stock?
Again, going back to past cycles of rising interest rates, research shows that your best bet is usually stocks that produce high levels of cash flow relative to the size of the company.
In fact, stocks with a low enterprise value compared to earnings before interest, taxes, depreciation, and amortization (EV/EBITDA, shorthand for cash flow) perform the best during Fed rate hike cycles, up 9% on average. And stocks with a low stock price compared to free cash flow are up 8.1% on average.
Fortunately, you don’t have to crunch the numbers on hundreds of stocks to figure out the best value stocks in the market. Our TradeSmith tools can do it for you.
If you’re a subscriber, simply go to the Invest tab on our website, click on Screener, then select +New Screener. That will take you to our exclusive stock Screener page.
Indicated by the green arrows shown above, I selected only stocks with a rating of Bullish or Strong Bullish.
Under Health Status, I wanted only stocks in a healthy state, so I selected the Green Zone. I then checked the box for stocks in an uptrend.
Finally, under TradeSmith Strategies, there are many categories to choose from here depending on your own preference, but I checked “Value.”
Then, under Display & Sort Results, I chose to show the top 50 stocks sorted by Health Grade to get the best value stocks in our database.
The screen resulted in 45 value stocks that also earn high marks by our proven TradeSmith rating system.
Many of them are real estate stocks, which also offer you the bonus of attractive dividend yields in the 1.5% to 3% range. Also well represented are financial stocks, many with solid dividend yields as well, plus several health care and consumer stocks.
One stock that caught my eye is biotech giant Gilead Sciences (GILD), a blue chip in health care with a $90 billion market cap. GILD has a Strong Bullish rating in our system. It triggered an entry signal last July and remains in the Green Zone in a healthy state, with a solid uptrend intact.
GILD’s EV/EBITDA ratio looks like a bargain at just 8.95. Plus, GILD shares trade at just 12.3 times earnings, and the stock pays you a rich 3.9% dividend yield while you wait for the stock to climb higher.
The switch from growth stocks to value stocks that’s underway looks like it has staying power. One way to potentially cash in on this shift is by using the TradeSmith Screener to scan for value stocks with upside potential.