- The price gap between growth and value stocks will narrow considerably but the timing is uncertain
- Investment managers warn against betting heavily against growth and towards value
Equity investors putting faith in growth stocks – stocks that are priced expensively relative to fundamentals because they are expected to grow fast – received a shock in early September when they sold off sharply.
But there was a consolation for those with a well-balanced portfolio. Value stocks – which look cheap relative to fundamentals such as dividends and earnings – did well.
“There was an absolutely huge rotation comparable to any extreme market environment that you would care to choose,” says Jason Williams, portfolio manager on the Lazard quantitative equity team in London. He notes that a rotation of this order away from growth stocks last happened during the bursting of the tech bubble in the early 2000s.
Investment managers attribute this phenomenon to an unwinding of imbalances that have built up over the past decade. Growth stocks have had a good run during this time, while value stocks have disappointed.
But even though many investors see September’s events as a foretaste of what is to come rather than a blip, most are reluctant to bet too heavily against growth and for value.
Georg Elsaesser, senior portfolio manager in quantitative strategies at Invesco in Frankfurt, echoes the views of many when he says: “It’s always tempting to time factors, but we never do it because our experience of more than 20 years tells us that if you want to time it you need very high hit rates, because if you get it wrong it goes very wrong.” For example, investors betting on value might find themselves investing in stocks that look cheap and grow steadily cheaper as they hurtle towards oblivion.
It is rare to see so much drama in a market that in headline terms did not change dramatically during the course of one month – the MSCI World index was up only 2.2%, in dollar terms. But much drama lay below the surface. The Lazard quantitative equity team has totted up the most expensive 20% of US stocks at the beginning of the month, based on measures such as price-to-book and price-to-earnings, and compared them with the cheapest 20%. The cheapest outperformed the most expensive by a staggering 9%.
Despite this yawning disparity in performance, investors cannot find a clear culprit for the sudden reversal in the fortunes of quality and value stocks. This lack of a clear reason underlines the structural instability of a market where expensive stocks have become so expensive and cheap stocks have become so cheap.
Will James, deputy head of European equities of Aberdeen Standard Investments in Edinburgh, suggests the influence of bond yields, which “started to edge up” a little after sinking to levels that looked unsustainably low. Low bond yields are good for growth stocks, because they reduce the discount rate used by analysts to price the net present value of their much higher earnings expected in the future.
Aside from bond yields, there is a sense among investors that growth stocks have been overbought, after rising for many years. Many of these growth stocks are US firms, including a large number of tech stocks such as Facebook and Apple. However, analysts say there are growth stocks all over the world, with many outside tech too. They point to the Swiss food and drink company Nestlé as one of many examples of a company that has managed to grow earnings strongly by expanding into lucrative new markets across the world.
Nestlé’s stock price fell in early September, along with many US tech stocks that have done well over the past year. In the value camp sit businesses that look cheap based on standard metrics, including many industrials, utilities and banks.
Many are in Europe and Japan, but by no means exclusively. For example, Californian utility stock PG&E has fared badly over the past year, but enjoyed a fillip in early September.
By the same token, if growth stocks look overbought, value stocks must look oversold. For this reason, analysts say that a fundamental reordering of the markets in favour of value stocks, way beyond what took place in September, looks poised to happen. However, any experienced investor knows that markets can be poised to do something for a long time, without doing it. Elsaesser of Invesco explains: “Whenever the gap between cheap and expensive has been very wide, we have seen a reversal at some point, where the most expensive stocks start to get cheaper, and the cheapest stocks start to get more expensive. This is a good environment for value.”
But although the spread between expensive and cheap stocks was, before September’s fall, its highest since 2008, and is still high even now by historical standards, Elsaesser says “we’re not saying there will be a reversal next week. It can take months or even years.”
James of Aberdeen Standard looks at the growth versus value debate from a different perspective from quantitative managers, because he prefers bottom-up stock picking. However, he acknowledges that even people like him have been forced to think about growth versus value because of the imbalances generated by the market’s faith in growth above value stocks, “given the extremes of the moment, we need to be cognisant from a tactical perspective”.
On the one hand, James worries about a downturn in the global economy, if the trade war is not resolved, hitting growth stocks. Many are priced so high that the market would be tempted to take profits on bad news.
On the other hand, he suggests that value “will probably continue to do relatively better, because a lot of negative news is priced into value stocks”. But while he cautions against keeping out of value stocks, “if I was very, very underweighted value at the moment, I would be nervous”, he also counsels a balance between growth and value stocks. He reasons that both groups will be vulnerable if economies fall into recession.
Other analysts emphasise the need, however, to distinguish between the different segments of value stocks. Cyrille Collet, head of equities at CPR AM, the quantitative and thematic investing arm of Amundi, in Paris, suggests that among the sectors brimming with value stocks, highly-leveraged sectors such as telecoms and utilities could do well, in a continuing environment of low global interest rates.
On the other side lie financials, for which “a low interest rate is really a nightmare, so it’s very difficult to be positive about this part of value”, according to Collet. Banks’ margins are thinned by low benchmark rates, which reduce interest on their loans; insurers earn less from their large fixed-income investments.
Another way of dealing with fears that growth stocks might be overbought is to try to distinguish ‘good growth’ from ‘bad growth’. Good growth stocks likely to be more resilient when other growth stocks are falling sharply.
“Ranking companies on the basis of sales or earnings growth tends to draw you towards more speculative glamour growth stocks that in the long run tend to disappoint investors,” says Williams of Lazard. “That kind of growth stock has given the growth style a bad name.”
Responding to this, Lazard tries to focus more on “businesses that are laying strong foundations to outgrow their peers in the future”, according to Williams. He looks for improvements in margins, lower debt ratios, and higher spending on capital spending and R&D relative to sales, compared with peers