Why This Quant Fund Manager Thinks Value Stocks Are The Place To Be For Now

Broadening the image to include emerging markets presents some serious implications from the extremely strong U.S. dollar, which has been at historical highs this year.

Why This Quant Fund Manager Thinks Value Stocks Are The Place To Be For Now

A few may have held out hope for a so-called "Santa rally" into the end of the year, but those hopes have failed to pan out. Historically, the last five trading days of December and the first two of January have been good for investors even though professional traders often take some days off during this period. A study conducted by LPL Research in 2020 found that the average return of the S&P 500 during those seven days is 78% more likely to be positive than during any other seven-day period. However, this has been a challenging month that capped a particularly difficult year for Wall Street. NEW YORK, NEW YORK - DECEMBER 02: Traders work on the floor of the New York Stock Exchange during ... [+] morning trading on December 02, 2022 in New York City. (Photo by Michael M. Santiago/Getty Images)Getty Images

Thus, investors have been looking for corners of the market that will likely hold up better than the broader market. In a recent interview with ValueWalk, Francis Oh, portfolio manager for the actively managed Qraft AI-Enhanced Next Value Fund, explained why he thinks value stocks will outperform growth over the next 12 to 18 months. Preference for value Francis believes history gives us good insight into what the market is likely to do. Although Oh notes that history is never guaranteed to repeat, he said it's highly likely that it will in the coming year, which means good things for value stocks and bad things for growth.

"For example, we are in the era of the high inflation, which is directly connected to the higher interest rate regime," Oh states. "We're also about to be facing some sort of recession. Either an economic or profit or earnings recession is coming. This kind of environment is definitely not good for growth strategies." He notes that up until the end of last year, everyone was excited about the first interest rate hike, but most didn't expect the Federal Reserve to push rates up to 4.5%. Francis states that the market was expecting 2.5% or slightly less than 3% about 10 months ago. "That kind of environment could be valuable for growth strategies, but right now, every single macro market regime is indicating that the value investing is way better or much more for this kind of environment," he explaines. "History is assuring us that, for example, in the higher inflation regime, value investing has a tendency to deliver better returns, especially for this year alone." Value outperforms growth

Oh notes that value was outperforming growth by over 10 percentage points this year, adding that it's natural for investors to look to value in a market environment like the current one.

"I guess until all this year, investors looking for some strategy can shoot for the moon," he said. "Right now, people are down to earth because right now, the most important asset in the market is cash… Cash is no longer trash… It's the most valuable asset in the market right now."

Francis advises investors to look at the private equity and venture capital industry, which is starting to downsize its investments into startup companies. Leveraged buyouts are shrinking rapidly because cash has become one of the most precious assets in the market right now. He believes this reality is true among individual companies and the stock market alike.

"People… are looking to the cash generation capability of the companies because the markets are so uncertain," Oh says. "… What we know is not always true, but often, value stocks are typically higher in terms of cash generation or free cash flow."

He added that this preference for companies with significant cash generation is another sign that value is the place to be for the next 12 to 18 months.

NVQ's top holdings favor value names

As of September, the top holdings in Qraft's AI-guided ETF that trades under the ticker "NVQ," included insurers Cigna CI , AIG, and MetLife MET , insurer and financial services company Prudential Financial PRU , and pharmacy chain CVS. Qraft's Chief explains that their NVQ model is overweighting insurance companies right now.

The fund's artificial intelligence shifted into that position in September, and a look at the insurance sector's performance that month showed that it was profiling better than the S&P 500 and other value strategies. NVQ's AI also started focusing on the computer market, banking and other financial sectors, and energy.

Of course, energy has been the one sector that outperformed much of the year. However, Francis believes that they were already fairly overweight on the energy sectors starting early this year when oil prices began to soar following Russia's invasion of Ukraine.

Lessons from history on recessions

Francis also looked to history for insight into whether we're in a recession or if one is around the corner, recalling his experience around the Great Financial Crisis. He said the atmosphere and morale were totally different in 2008 from what we're seeing now. He adds that many fund managers tried to deflect talk about the potential risks, saying it could be too complicated for most investors to understand.

He noted that many investors didn't see the shadow banking system behind everything. Oh believes most investors were fairly naïve until companies started collapsing and that the Lehman Bros. collapse was probably the only moment the market was in panic.

However, in 2022, he said investors are extremely concerned because they're seeing a possible recession, and 4.5% interest rates haven't been seen in the last 15 years.

"Investor sentiment is much worse now because, at least for me, I feel like we're in the driver's seat in a car speeding around maybe, right now, 80 miles per hour, but we're able to see either a cliff or dead end around one mile away," Francis explains. "We're wishing that someone will be coming along and able to either demolish the wall or dead end or build another bridge to support the market."

He's not optimistic about the markets right now, and he believes investors are even more fearful because the possibility of a recession is much stronger now.

Potential triggers of the next recession

The fund manager warns that it's highly likely the market won't be able to solve its problems on its own and that the market is getting worse fast. He drew attention to the recent gilt crash in the U.K. market, which he said meant that the market wasn't working normally anymore.

As a result, Francis believes the market requires interventions from higher forces to adjust it. However, for steps similar to those taken in 2008, he believes some prerequisites are required, namely, a similar level of impacts to those that occurred around the Lehman Bros. collapse.

Qraft's Chief doesn't foresee another such collapse, as the U.S. economy is strong right now. On the other hand, broadening the image to include emerging markets presents some serious implications from the extremely strong U.S. dollar, which has been at historical highs this year.

He also warned that we could see some negative societal effects. In fact, Oh believes the weakest link in the global financial system could be one of the emerging markets, although he added that this could be a very pessimistic prediction. On the other hand, the weakest link could be a central bank that doesn't enter the quantitative easing phase unless they're able to see "one obvious victim in the market."

Another area of particular weakness is the Chinese property market. Some of Oh's friends are working in China, and they continuously tell him that this year is far worse than 2008. Property bonds are among the most popular investment instruments in China, and they've all fallen to 60% or 70%.

It's clear that the Chinese property market is in trouble. The quant manager notes that there have been several cases over the last six to 12 months in which the Chinese government wasn't willing to bail out struggling companies in the sector.

Active versus passive investing: when to use both

Oh also addressed the push and pull that occurs between passive and active investing. Having worked at one of the leading operators of passive funds, he understands the "beauty" of passive investing, particularly for those investing for the long term. He notes that passive investing offers a wide array of low-cost options for investors.

"Passive investing is giving you a very effective way of managing your portfolio to have a very good market beta exposure," he pointed out. "That is one very positive thing about it, but when we think about Warren Buffett and the other very well-known, world-famous value investors in the world, his approach is not necessarily the passive investing… When we look at Berkshire Hathaway's BRK.B portfolio not having 500 stocks the same as the S&P 500, those names in Berkshire Hathaway are selected names carefully decided and invested by himself or the other senior leadership of Berkshire Hathaway"

Qraft's Chief adds that passive investments could be good entry points for investors who don't fully understand or aren't well-trained about investing, especially when investing for retirement. On the other hand, he believes passive investment options might not be the best for investors who can analyze market signals and interpret them into investment opportunities.

Democratizing quant investing

One of Qraft's missions is to democratize quant investing by applying an artificial intelligence model to portfolio construction via an ETF. Oh feels their NVQ portfolio and performance are similar to the portfolios managed by the top quant hedge funds.

However, those top-performing hedge funds hire hundreds of portfolio managers and analysts to study and analyze market data. They look for patterns that will enable them to generate alpha and then implement those patterns as portfolio strategies.

Francis explains that they only have about 80 employees globally right now, which enables them to keep their costs down by leveraging AI instead of manpower. He feels their AI works similarly to the portfolio managers at some of the top-tier quant hedge funds by finding patterns that offer a greater chance of delivering alpha.

Michelle Jones contributed to this report.