Slow and steady winds the race
After years of languishing behind growth stocks, value stocks are back in demand. The breakthrough in finding a vaccine against Covid-19 and the Democratic sweep in the US election, spurred a rotation into value and out of growth. Investors positioned correctly for the shift are sitting on handsome recent returns. But equally there are investors who missed the change in direction. For both groups, there is now a dilemma: stay in value and risk the reflation story being yet another short-lived move or remain in growth and lose out from a potentially more longer lasting rotation into value?
Growth investing: caught between tailwinds and corrections
In a world starved of economic growth, the rarity of companies with earnings growth causes their prices to be bid up. Since the 2008 crisis, the disinflationary forces of ageing populations, automation and enormous public debts have conspired to push interest rates down across the world. Lower interest rates effectively translate to future earnings being worth more today.
That is a powerful tailwind for growth stocks, which, by definition, have more future growth embedded into their business models - but it’s also a vulnerability. If anything, the greater risk is interest rates rising from here, and given that they are so low, even a small increase could create an outsized impact on the discount rate and drag the present value of future earnings down sharply.
There is also the issue of the longevity of growth. Growth cannot continue indefinitely and there will inevitably come a point when earnings growth will slow down, and the faster the growth rate is today, the greater the magnitude it could fall by in future.
For these reasons, while growth companies have strong tailwinds, they are also exposed to sharp corrections.
Wide divergence in daily returns between growth and value stocks
Source: Fidelity International, MSCI, Refinitiv DataStream, January 2021. MSCI Europe indices (LC). Past performance is not a reliable indicator of future returns.
Value investing: cheap or obsolete?
Value investing is generally described as the pursuit of stocks that are cheaper than the wider industry or market. It’s essentially a bet that cheaper stocks will mean revert, generating profits for investors in the process. But it’s a misleading view because a cheap company is cheap for a reason. Brick and mortar retail, tobacco and fossil fuel companies are examples of industries on low valuations because their fundamental business models are under threat from online stores, healthier lifestyles and renewable energy.
Since the peak for value stocks in December 2006, the value index has fallen to levels last seen in the 1990s. But a tentative reversal started in September 2020 and gathered pace from November. How long can this winning streak for value last?
Moving beyond growth and value to intrinsic value
Because the arguments for both growth and value can be debated, the market often changes its mind as to which is best placed for the current conditions. This can create large rotations, which can be costly for investors positioned on the wrong side. Given that the timing of such rotations is nearly always impossible to predict beforehand, most investors have experienced this pain.
Historically large fluctuations in daily returns between value and growth
Source: Fidelity International, Refinitive DataStream, 1 February 2021. Data from Jan 1997 - Jan 2021. MSCI Europe Value and Growth indices (LC). Past performance is not a reliable indicator of future returns.
Moving beyond simply looking for cheap or high growth stocks and using the principle of buying companies priced below their intrinsic value can lead to better investment outcomes.
This approach encapsulates both the price and outlook for a company, rather than being a one-dimensional multiple comparison or growth assessment. It’s a research-intensive method but offers a more reliable and consistent way to achieve investment goals in the long term.
The blend philosophy has a number of benefits for investors. Firstly, it takes advantage of the capital appreciation of growth stocks and the reliable income and dividend streams of value stocks. It also allows investors to have exposure to the different factors that take turns in market leadership over the course of a cycle. Value stocks tend to do well early in an economic recovery, especially the cyclical ones, while growth stocks tend to outperform during bull markets, which are normally fuelled by falling interest rates and rising earnings. Combining growth and value stocks in a portfolio could offer a more prudent strategy for balancing risk and return over the long term.
We also know that while valuation multiples often prevail in the short term, earnings and business models dominate stock performance in the long run. That’s why understanding the value creation path, which allows us to better forecast the long-term fortunes of companies, is critical.
Earnings have a bigger impact on performance over the long term
Source: Credit Suisse, March 2019. NTM P/E and NTM EPS. Median contribution to return since 1964. Standard & Poor’s, Thomson Financial, Factset. Past performance is not a reliable indicator of future returns.
Sector selection or stock picking
One legitimate question is whether this blend approach can be applied on a sector or industry basis where a portfolio is comprised of a mix of value and growth industries. The problem with this system is that it is crude and leaves returns on the table.
It’s true that certain industries are predominantly value or growth oriented, but that belies the range of companies within a sector with an array of business models, technologies, management qualities, growth rates, costs of capital and valuations. For example, banks are facing a tough challenge from low interest rates and weak economic growth, and are broadly seen as a cyclical, value sector. But within the industry there are companies with vastly differing prospects and some with even faster growth rates than the average tech company. A diligent investor can find financial companies displaying strong growth qualities and selling cheaply i.e. below their intrinsic value. A blanket industry approach will dilute the factor exposure and miss out on alpha from stock picking.
Blending the best of both worlds
In our opinion, investors can exploit the benefits of both value and growth factors by following these principles:
- Pick stocks, not styles: sector picking is ultimately self-defeating because of the wide underlying differences between companies within the same sector. Instead, pick the most compelling names that fulfil the criteria of selling below their intrinsic values.
- Focus on the long term: blend investing rarely wins the factor race in the short term given that it’s valuation multiples that mostly determine short-term returns. In the long term the story is different: the companies with the greatest value creation will produce the best returns.
- Use return on invested capital (ROIC) as a starting point: a growth approach emphasises earnings growth, while a value approach emphasises cheapness. An ROIC approach links returns to invested capital, integrating the income statement and balance sheet. This is a more complete metric and a good starting point before undertaking further research to measure intrinsic value.
- Look for inflections in the stock story: inflections are a change in direction of the fortunes of a company. These can be found in both growth and value investments and can be very profitable. For example, a value inflection could be found in Volkswagen. Following the ‘dieselgate’ scandal, the stock became cheap but the company was already heavily investing in the electric vehicle revolution and it could be forecast that returns would inflect in the next 3-5 years. A growth inflection example is online property website Rightmove. While it was relatively expensive, it was transitioning to a period of post-capital expenditures where investments would gradually fall. With high margins and little capital requirement, the conversion of sales to earnings would start rising. Both VW and Rightmove fit within a blend portfolio but one or the other company would generally be omitted from a purely growth or value portfolio.
- Don’t overlook special situations: a simple growth, value or industry approach may ignore compelling special situation investments that don’t neatly fit into a factor category. One example is Takeaway.com, a Dutch food delivery business that owned a loss-making but number two player in the German market. Takeaway.com subsequently bought the number one player in Germany, also loss-making, but the combined business became profitable.
Both growth and value profiles offer attractive investment opportunities but returns ebb and flow, with alternating periods of outperformance and underperformance. But investors do not have to make a mutually exclusive choice between the factors. By taking a more balanced blend approach, they can gain exposure to both growth and value stocks and select opportunities that do not naturally fit into either category such as special situations. The important point is to focus on companies selling below their intrinsic value with high returns on invested capital. This philosophy may not lead to the highest short-term factor returns but over the longer term, it should provide a smoother journey towards investment objectives.
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