A top value fund manager who nailed this year's market rotation gives his 3 top stock picks in the sector

• Bill Smead predicts value stocks will outperform growth as AI hype fades in the stock market.
• He warns of potential S&P 500 underperformance due to high market concentration and valuations.
• Smead highlights three value picks amid changes he sees in the housing market.

It's once again good to be a value investor. After a rough couple of years, the segment of the stock market is back to outperforming its growth counterpart.

Bill Smead — who co-manages the Smead Value Fund (SMVLX), up 6.75% this year — has long been betting on such a switch. In September, Smead warned about the AI space being overhyped and that high valuations would eventually spur a rotation into unloved areas of the market.

That shift has since unfolded, with energy, industrials, and small-cap stocks benefiting from investors' growing skepticism that the hundreds of billions of dollars being spent on the AI infrastructure buildout will pay off, while fears also percolate around the idea that AI will upend many industries and businesses.

Smead, whose fund Morningstar data shows has outperformed 97% of similar funds over the last 15 years, thinks the outperformance is set to continue. Even with the recent shift underway, valuations remain remarkably high, he said.

A self-styled disciple of Warren Buffett, Smead's preferred valuation measure is total stock market capitalization-to-GDP, also known as the Warren Buffett Indicator. The measure currently sits at an all-time high of 216%.

Concentration is also at historic highs in the stock market, Smead warned. It's a cocktail for poor returns over the next decade for the S&P 500 — something top banks like Goldman Sachs and Morgan Stanley have warned of in recent years.

"The popular securities and momentum are at the end of the greatest 15-year run in history," Smead said. "Most everybody owns too much of their money in 70% of the S&P that's not going to do well in the next 10 years."

Smead then warned of a sort of selling spiral, where investors — particularly those who are older — start to move their money out of growth stocks into bonds for safety after a period of underperformance.

3 value stock picks

So, where is Smead placing his bets for a continued value rotation? He shared three firms he thinks are particularly cheap, starting with a couple of homebuilders: DR Horton (DHI) and Lennar (LEN). The stocks make up 4.9% and 3.82% of SMVLX, respectively.

After a cold stretch in the housing market, as high mortgage rates priced out homebuyers and kept owners frozen in place, things are starting to thaw—and demographics make the sector poised to boom, Smead said.

"There's more 20-40-year-olds than we've ever had, and there's fewer homes owned by 20-40-year-olds than we've ever had," Smead said. "When the worm turns, and they get their chance to buy homes, we have to build a lot of homes."

Interestingly, Smead's view of homebuilders aligns with his bearishness toward growth stocks. Because growth stocks have done so well, he predicts prospective homebuyers will cash out recent gains to fund their purchases.

"You know why Willy Sutton robbed banks don't you? Because that's where the money was. So, if you're going to rob someone to get money, who would you rob right now? Well, you'd rob the S&P 500, and you'd rob tech stocks, and you'd rob large-cap growth stocks," he said. "Notice, the last couple of months, money is coming out of those, and mortgage rates have been coming down."

The other name Smead pointed to is the moving and storage company U-Haul (UHAL), whose shares he described as "very depressed."

The firm is well-positioned to benefit from the eventual housing boom Smead expects, as people would increasingly need to move and store their belonging.

Plus, he thinks the market is underpricing the strength of its balance sheet.

"The entire market capitalization of U-Haul is represented by their storage units, and you're getting a $5 billion leasing business for free," Smead said.