Stockholm (Ekonamik) – Over the past decade, value stocks greatly underperformed their growth counterparts – pricier stocks with higher growth potential – and we have been hearing more and more about the death of value investing. Investors often think of growth as the opposite of value and the other way around. As Andrew Ang, Head of Factor Investing Strategies at BlackRock, writes, “many investors pit value against growth like two gunslingers in an old western movie.”
For Warren Buffett and many others though, all investing (value investing, growth investing, or whatever flavour of investing one may think of) involves buying something for less than that something is worth. Be it a fast-growing company, a struggling business, a used excavator or a Van Gogh painting. As Buffett once wrote, “growth is simply a component – usually a plus, sometimes a minus – in the value equation.” At the risk of oversimplification, most market participants usually refer to stocks with low price-to-earnings or low price-to-book as value stocks, whereas high price-to-earnings and high price-to-book stocks are regarded as growth stocks. This week, our review of asset manager insights suggests many are starting to wonder whether investors should go for Value as growth becomes expensive.
Value Stocks Underperform: Technological Disruption
If we go down the path of differentiating between growth and value stocks using one or more valuation metrics, value stocks – with low prices relative to earnings or book value of equity – have been the underdogs of equity markets for a prolonged period of time. “If we look at ten-year rolling yields since 1936, we can see that value as an investment style has never before underperformed growth over such a sustained period as it has in recent years,” said Hendrik Leber, Managing Partner at ACATIS Investment, in early May. One reason behind the recent value underperformance stems from technological disruption.
“We don’t think that this is a coincidence,” claims Leber, adding that “it is crucially related to the technology-driven disruption we are seeing in virtually all industries.” Andrew Ang from BlackRock had the same thought in September of last year. “FAANG (Facebook, Amazon, Alphabet, Netflix and Google) stocks are in the news, but the value drawdown is more than the great run by FAANG,” wrote Ang. “The breakout of growth firms is quite widespread,” he said, further adding that “not only consumer finance and technology; growth firms are also outperforming in more staid industries like food products and chemicals.”
Daniel Taylor, Gregory Bond, Charlotte Lin and Shicong Wang from Man Numeric appear to have noticed the effect of technological disruption on the earnings growth outcomes of value stocks relative to growth stocks. The Man Numeric team wrote that “the spread in earnings growth between more expensive and cheaper stocks widened significantly in the mid-1980s and has been relatively wide over the last 30 years, compared with the prior 20 years.” They speculate that if the increase in the earnings growth spread is attributable to technological innovation, globalization and access to cheaper capital over the last 30 years, then there is “some comfort that value could prosper if some of those conditions abate.”
Over-extrapolation and Indexing
The over-extrapolation of growth prospects may serve as another reason for the underperformance of value stocks during growth environments. The team from Man Numeric wrote in September of last year that “it is pretty clear that market participants over-extrapolated the growth potential of the Nifty Fifty in the early 1970s and the Technology sector circa early 2000.” However, the Man Numeric analysts said that “it is less clear that this is the case today, with several of the FAANG stocks trading at, or sub, market multiples.”
Andrew Ang corroborates Man Numeric’s conclusion, saying that “we also see investors’ biases in over-extrapolating future growth as expensive stocks have surprised on the upside with strong earnings, but cheap stocks have not.” Rory Bateman, Head of Equities at Schroders, argued earlier this month that the shift to passive investing might have played a role in the outperformance of growth stocks as well. “Equity markets have seen huge inflows of passive money over the last few years,” said Bateman, emphasizing that “this passive money is essentially forming what is known as a “momentum trade”, meaning the money goes towards those companies that have already performed well and so form a larger weighting of a given index.”
Expectations for Value and Growth Stocks
In March, Laurent Nguyen and Gabriele Susinno from Pictet Asset Management, wrote that in recent months “value stocks have witnessed something of a revival as a slowdown in the world economy has raised doubts over “growth” companies’ ability to deliver a sustained expansion in profits.” Schroders‘s Bateman, agrees with the duo’s conclusion, arguing that “this extreme outperformance means growth stocks could look very vulnerable if we were to see a “risk-off” environment.” He reckons that this “risk-off trade would likely be most evident in these highly-rated quality and growth stocks, particularly if these companies were to start missing their earnings forecasts.”
Whereas Bateman acknowledges that “such a risk-off environment would clearly be negative for the overall equity market,” the elevated valuations of growth stocks means this group of stocks “could be the most negatively affected, and value could perform better on a relative basis.” Nguyen and Susinno argue that “it would appear that the conditions are in place for value to outpace growth,” but investors “looking for value need to be far more discerning.” The duo wrote that “while growth stocks are, we believe, likely to suffer as the economy and corporate earnings growth both slow in the coming years – globally, company profits are expected to rise at about 5 per cent this year compared to 14 per cent in 2018 – their cheaper brethren aren’t necessarily the bargains they appear to be.”
Explaining the conclusion, Nguyen and Susinno wrote that “finding a genuinely cheap company isn’t easy,” because “stock prices can deviate significantly from a firm’s underlying value, and sometimes for a very long period of time. Further complicating matters is that popular valuation metrics such as the price-earnings (P/E) ratio, price-to-book ratio or dividend yield don’t always paint an accurate picture.”
Towards the end of 2018, Peter van der Welle, Strategist at Robeco, said that “we think now is a very good time for investors to introduce value stocks to their portfolios.” One argument in favour of value stocks is the rising interest rate environment. “Rising rates will hurt the more rate-sensitive momentum and growth stocks and gradually more fine cracks will appear in this momentum-driven bull market, thereby increasing the downside risk,” wrote Welle. “This environment will thus also set the stage for restoring more balance between the typical initial indifference of investors to value stocks and their corresponding disproportionate enthusiasm for growth and momentum stocks.”
At the end of March, Nick Kirrage, an equity value manager at Schroders, also explained why now might be a good time to consider value stocks. “When we look across investments in the market today we see a huge bias in investors’ portfolios towards growth-type investments, said Kirrage, emphasizing that this bias “presents an opportunity, to diversify and buy into a strategy that has a great long-term success record.” On the question of “why now,” Kirrage said, “because, we believe, with value stocks at such attractive levels the opportunity has never been greater.”