Stocks just had their worst first half of the year in more than 50 years. Even if past performance is indicative of future returns—to mangle the obligatory investment disclaimer—investors in mutual and exchange-traded funds can position their portfolios to take advantage of positive trends that are likely to unfold in the second half.
Now is the time to focus on funds that favor value versus growth stocks; shares of profitable small companies; and cyclical sectors, including financials, market strategists tell Barron’s. It is also worth looking at dividend-oriented stock funds.
The market narrative has been dominated this year by concerns about the U.S. Federal Reserve’s plan to tame inflation with aggressive interest rate hikes, and the accompanying fears of recession. The investing narrative, meanwhile, has focused on the value-growth war. That shows no sign of changing in the second half of 2022.
The Russell 1000 Growth index (.RLG) is down 28% since the start of 2022, while the Russell 1000 Value index (.RLV) has fallen 13%. The surge in oil and gas prices is a big reason why value has outperformed growth this year: Energy stocks have soared compared with sectors such as tech that have suffered a drubbing.
Phil Huber, chief investment officer at Savant Wealth Management, says the value-versus-growth cycle can last for an extended period, and while some investors might be wondering if it is too late to get in, he believes there is still time.
“Having, and maintaining, a bias toward value stocks is probably the better posture to have as we look ahead to the next few years,” Huber says, adding that research shows the value spread—meaning how cheap value stocks are relative to expensive growth stocks—remains historically wide. That suggests there is still opportunity in value.
Jill Carey Hall, U.S. equity strategist and head of small- and mid-cap strategy at BofA Global Research, echoes that view.
“We still like value,” she says, especially when comparing the Russell value versus growth indexes. “In general, we have found that value is still historically inexpensive versus growth. We haven’t really seen valuations normalize yet.”
The iShares Russell 1000 Value exchange-traded fund (IWD) tracks the Russell 1000 Value index.
One actively managed value fund that has been performing well this year is the Neuberger Berman Large Cap Value Fund (NBPIX). It is down about 8.3% for the first half of the year, after returning more than 28% last year. Its top holdings include Exxon Mobil (XOM) and Procter & Gamble (PG).
On the small-cap front, John Lynch, chief investment officer for Comerica Wealth Management, notes the key is to find profitable companies. “When I say profitable, it really comes down to quality,” he says.
About 40%-45% of the companies in the Russell 2000 index (.RUT) of small -cap stocks are unprofitable, he says, compared with 10% in the S&P 600 small-cap index (.SML). “It will be really important to have the platform of profitability for the small-caps to outperform,” says Lynch.
The iShares Core S&P Small Cap ETF (IJR) tracks the S&P 600 index, while the iShares Russell 2000 ETF (IWM) tracks the Russell 2000 index. IJR is down nearly 19% year to date, versus minus 23.5% for IWM.
Another area to consider is dividends. Nancy Tengler, chief investment officer at Laffer Tengler Investments, says investors should focus on funds that invest in “the highest quality names”—companies that are paying dividends out of earnings. She notes that FedEx (FDX) and Target (TGT) are among the companies that recently raised their dividend payouts.
So far this year, higher-yielding stocks have outperformed those of companies with faster dividend growth.
As for which sectors to focus on, Philip Straehl, global head of research at Morningstar Investment Management, says financial-sector equity funds—which provide investors access to a basket of financial-sector stocks, including banks—“have underperformed, relatively speaking,” but are “fairly valued,” according to Morningstar’s analysis.
“We think the banks are well-capitalized and they can withstand a potential downturn in the future,” Straehl says. “They also offer a decent yield, both in terms of dividends and buybacks.”
BofA’s Hall says financial stocks have “seen a huge improvement in quality following the global financial crisis” and are now “one of the highest-quality sectors within the S&P 500 (.SPX).”
There are several ETFs that offer investors exposure to financials, including SPDR S&P Regional Banking ETF (KRE), Vanguard Financials ETF (VFH), Financial Select Sector SPDR Fund (XLF), and SPDR S&P Bank ETF (KBE).
One way to screen for quality is to look at earnings volatility. “The S&P publishes quality rankings for stocks [which] look at a long trend of a stock’s earnings stability, or volatility,” says Hall.
While it may be hard for investors to consider adding to their portfolios when returns are negative, it is important to take the long view. “Stay steady and, if possible, if [you] have the funds, keep adding during this period because what follows a bear market? A bull market,” says Tengler.
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