Inflation could end tech stocks’ winning streak in 2022—and pump up these stocks instead

“We think that any way you look at it, value stocks have the advantage versus the overall market and growth stocks,” says John Thorndike, cohead of asset allocation at fund titan GMO. “That’s within sectors, across sectors, large-cap or small-cap.” And if high inflation persists, Thorndike adds, value stocks will get a double boost. That’s because the cyclical industries that are the bulwark of value—including financials, energy, materials, housing, and robust consumer brands—pack strong pricing power at a time when a growing economy means strong customer demand and higher costs. “These value stocks are unique in providing protection against inflation,” concludes Vitali Kalesnik, a partner at Research Affiliates (RA), an esteemed investment strategy firm that sees a big rebound on the horizon for value.

If the value bulls are proven correct, it would mark a sea change. Such market sages as Warren Buffett and his mentor, Benjamin Graham, secured their positions in the investment pantheon by betting that “value” stocks—cheap in relation to their earnings and assets—will beat the pricey, glamorous “growth” players over time. And academic studies confirm that during long periods, value indeed outperforms by a wide margin. But the experience of the past 15 years—and especially the fabulous performance of the tech sprinters—appears to turn that conviction on its head. In recent years, the champs haven’t been automakers, energy names, and brick-and-mortar retailers but the Googles and Amazons and Nvidias and Teslas, which have most recently mined the pandemic to deliver some of the best short-term returns in the history of equity markets.

But growing numbers of investors think we may be about to witness the revenge of the dogs. Part of that analysis comes down to a belief that markets are due for a so-called reversion to the mean. In a recent study, Did I Miss the Value Turn?, Kalesnik and two colleagues from RA, which fashions investment strategies for $171 billion in mutual funds and ETFs, crunched decades of data. They found that because growth has been thumping value for so long, value stocks are now even cheaper relative to growth stocks than they were at the peak of the tech bubble two decades ago. Value went on to outperform growth for six straight years after the dotcom implosion. The RA paper argues that investors who bet on a similar pivot today will pocket market-beating returns over the next decade. That matters a lot, because some of the market’s current high-fliers are likely to level off or tumble—and inflation is a big reason why.

Put simply, value stocks are those whose share prices are low relative to their companies’ economic fundamentals; growth stocks have high prices relative to those fundamentals. Investors define growth stocks as the 50% of companies whose ratio of market cap to a basic measure (such as earnings or the “book value” of their assets) is higher than the median; the value tier comprises the half whose ratios fall below it.

Today the dominant growth stocks are the giants of software, social media, fintech, and smartphones and other IT devices: Alphabet, Microsoft, Apple, Amazon, and the like. The top value categories are financials, health care, industrials, and energy, encompassing producers, pipeline operators, and equipment suppliers. Retailers and automakers—the traditional ones, not Tesla—are also long-standing value plays that look cheap today.

Growth is the domain of great expectations. An elevated price/earnings or price/book-value ratio suggests that investors are banking on strong future earnings growth to justify a company’s rich valuation and deliver big returns. 

And that’s precisely why economic conditions like today’s can ring alarm bells for growth investors. The risk isn’t that the tech juggernauts will go out of business: Amazon is clearly no Webvan. But in times of recovery accompanied by inflation, rising prices tend to eat into the profits of growth companies—while cyclical value stocks benefit from surging demand that gives them strong pricing power and protects their margins. 

The rising interest rates that accompany higher inflation also reduce growth stocks’ appeal: As safer bonds begin offering higher yields, they start looking more attractive than higher-priced, volatile equities that often don’t pay dividends. 

The bottom line: Investors become less willing to pay as much for growth stocks’ far-off profits, and prices and P/E multiples tumble. Indeed, the last time a strong economic recovery coincided with relatively high inflation, between 1982 and 1984, value outperformed growth by 25 percentage points, according to research by RA’s Kalesnik and Ari Polychronopoulos.  

To many investors, that concatenation of stronger growth and higher inflation looks increasingly likely. In October, the consumer price index (CPI) surged at a 6.2% annual rate, a 31-year high. As the economy reopens, “labor is the key driver of inflation, and in recent months we’re seeing more and more wage pressures,” says Zhiwei Ren, managing director at Penn Mutual Asset Management. “The fast-food industry is raising wages by 10% to hire workers.” Ren notes that no one is sure whether the multitude of workers who left the labor force during the pandemic crisis are coming back. “Chairman [Jerome] Powell is asking the same question,” he says.

For Tim Murray, capital markets strategist at T. Rowe Price, the big question is whether the current bout of inflation is temporary, or driven by long-lasting structural forces. “If it’s caused by bottlenecks, that will get fixed,” he says. “But if inflation is structural, it will hang around for the next decade.” He cites two signals that fast-rising prices may be entrenched. One is labor, where he echoes Ren’s view. The other is the surge in housing costs. “The ‘shelter components’ represent 40% of the CPI,” he says. “Because of the work-from-home economy, people want a nice house and go back to the suburbs.” All those buyers chasing a tiny inventory of homes are driving up prices. “That’s a longer, structural issue,” says Murray. 

Another threat, warns William Luther, an economist at Florida Atlantic University, is that as companies see big inflation numbers month after month, they’ll start building large price increases into long-term contracts, including labor agreements. “That trend bakes in future price increases, leading to a cycle of more increases,” he says. 

That cycle is potentially vicious for growth stocks—so why is it virtuous for value? Value stocks’ biggest edge is that they’re “consumption sensitive,” as Kalesnik puts it. They sell exactly the so-called cyclical goods that society wants more of in an economic recovery: farm equipment, plastics, natural gas, furniture, mortgages. 

Just as important: As the desire for their products jumps, these companies can raise prices at a pace that beats the march of inflation, notes Thorndike of GMO. For many products, from oil to new homes to airline seats, producers can lift their output and supply only gradually. But consumers want to buy now, and are willing to pay more. Those eager dollars swell prices and profits.

Value stocks are also far less vulnerable to a jump in interest rates: Because they’re cheaper, they’re more likely than growth stocks to look attractive in comparison to higher-yielding bonds. And one category of value stocks—banks—stands to benefit directly, as rising rates lift the profit margins on their mortgages and credit card loans. 

High inflation is already helping some sectors within value, notably commodity and real estate stocks. The Vanguard Energy Index Fund, with heavy holdings in Exxon Mobil, Chevron, and Schlumberger, has jumped 20% since September. Vanguard’s real estate fund also rebounded, adding 7% from mid-October to mid-November, while the Vanguard industrial fund surged 9% over that span. More persistent price increases will only widen that trend, says Kalesnik: “Today, value is an essential hedge against the inflation threat.”

Value stocks have another factor in their favor: Cheap usually beats expensive in an economic recovery. In fact, value has outperformed growth in five of the past six recoveries from deep recessions, according to Kalesnik and Polychronopoulos. 

The pandemic, of course, played to the advantages of Big Tech, while hammering value stocks. Amazon thrived delivering goods to the doorsteps of stay-at-home America, while Apple and Microsoft prospered selling IT gear for working from your den, and PayPal feasted on the boom in virtual payments. By contrast, the lockdowns pummeled sales of industrial equipment, energy products, travel, and hospitality. 

Ordinarily, value would have raced ahead of growth in the recovery that followed, but the lingering economic and cultural impact of the Delta variant, and fears of more virulent versions in the future, have held it back: The two categories have been roughly neck and neck over the past 12 months. More tellingly: In the 11 years since Vanguard launched its Russell 1000 Growth ETF (VONG) and Russell 1000 Value ETF (VONV), growth has risen 460%, outpacing value’s 180% increase by two-and-a-half times. That’s why value stocks, even today, still trade at dotcom-bubble-era lows in relation to growth stocks, according to the authors of Did I Miss the Value Turn?

Those authors predict that when a recovery fully takes hold, that dynamic will change. Hordes of Americans are already returning to stores and restaurants, boarding planes for vacation destinations, and refilling their gas tanks to get back on the road; sector after sector of the economy will follow consumers’ lead.  

–0.9%

expected annual performance for large-cap U.S. stocks through 2030 after inflation is taken into account, according to investment strategy firm Research Affiliates

But what they don’t foresee is a continuation of the bull market, in part because valuations are so high right now. The RA team forecasts that U.S. stock prices overall will decline around 0.4% a year over the next 10 years, once inflation is taken into account, while large-cap equities will fare even worse, declining an average of 0.9% annually after inflation. In that climate, the authors conclude, value stocks, underpriced today, “are the only asset likely to generate a 5% to 10% real return over the next decade.” 

Most of those returns, the team predicts, will come from abroad. A portfolio of value stocks will garner 7% annual gains in Japan, they estimate, and 8% in Europe. The biggest gains in any class, they predict, will flow from a portfolio of emerging-market value stocks at almost 10% a year. Thorndike says that GMO is especially keen on emerging markets, and developed nations outside the U.S. “Value is cheaper than growth to the same degree everywhere, but those markets are much cheaper than the U.S.” (In these relatively risky markets, mutual funds and ETFs are the safest play for U.S. investors; for options, see “Funds for the value rebound” below.)

In the U.S., where the majority of Americans hold most of their money, RA posits that value stocks will be good for real returns (that is, after inflation) of around 4.5%. That’s hardly stupendous, but it’s more than five percentage points better than large-cap equities overall—a substantial edge that would lead to huge outperformance over a decade. Buying what’s cheapest goes against both recent history and the advice often dispensed on Wall Street. But thanks to unprecedented economic circumstances, the days of the downtrodden may have arrived.

Funds for the value rebound

These mutual funds focus on stocks with lower price/earnings ratios—and could soar in a higher-inflation market.

The T. Rowe Price Value Fund (TRVLX) comprises big-cap U.S. stocks and boasts a five-year annualized return of 14.5%. The fund tilts heavily to financials and health care. Among its largest holdings are Morgan Stanley and Wells Fargo, along with a raft of industrials such as Danaher and the breakup-bound General Electric. Expenses are a modest 78 basis points,or 78 cents per $100 invested. 

The cheapest of cheap value lies in emerging markets—and on that relatively volatile turf, the diversification that comes with an ETF can be crucial. The Pimco RAFI Dynamic Multi-Factor Emerging Markets Equity ETF (MFEM) uses a strategy called fundamental indexing, purchasing stocks based on their size in the economy rather than their market cap. That gives big, stable industrials and energy players with low valuations a heavy weight. Among the top holdings: Gazprom and Lukoil of Russia and automakers Hyundai and Kia of South Korea.

The Vanguard Value ETF (VTV) is extremely low cost at four basis points. It has returned just 9.9% annually over the past three years, but it should outperform going forward because value is so underpriced. Top holdings include strong dividend-payers such as JPMorgan Chase, Procter & Gamble, and Pfizer. 

The Dimensional Fund Advisors U.S. Large Cap Value Portfolio (DFLVX) is a passively managed fund that’s in all the right places: health care, industrials, and energy. It also holds a bunch of undervalued tech stocks, including Intel and Thermo Fisher Scientific.

A version of this article appears in the December 2021/January 2022 issue of Fortune with the headline, “Stocks and funds for 2022: Who wins when prices rise?”