Value vs Growth
When investing in equity markets, there are two principal approaches to generating excess return - invest in companies with significant earnings growth potential or companies that trade below their perceived intrinsic value in the belief that the market is mispricing the stock. These approaches are known as growth and value investing respectively and they have displayed dramatically differing results throughout the varying market conditions of the past two decades.
Value investing uses strong corporate fundamentals to find investment opportunities. The father of value investing, Benjamin Graham, looked for dividend-paying companies with a low price relative to earnings and book value, a history of earnings per share growth and durable debt to asset ratios. There are many reasons why a stock may become undervalued. For example, changes in public perception or corporate and legal pressures may turn other investors off, while value investors may determine these issues will subside.
Growth stocks, by comparison, are quality companies that are likely to increase revenues and earnings at a faster rate than the industry average. These companies typically reinvest most of their earnings and the anticipated compounding effect of reinvestment and growing sales results in comparatively higher prices and price ratios. As a result, they tend to look relatively expensive. Moreover, due to the greater weight of value attributable to forecasted earnings, these companies often experience a greater degree of share price volatility.
The last two decades
It is no surprise that diligent fundamental analysis should provide long-term investment gains and this approach has been validated with value stocks having outperformed growth stocks over the last two decades. There have been two major market incidents during this time.
In the run-up to the dot com crash of 2000-01, companies with online exposure were expected to grow rapidly as internet usage boomed. These assets were ultimately subject to euphoric pricing and the bubble eventually burst with growth stocks suffering a severe correction during a period in which value stocks were relatively unaffected.
The global financial crisis occurred seven years later. Led by banks and financials experiencing a liquidity crisis, the entire stock market severely corrected as the debt-driven sub-prime housing bubble collapsed. In the time between these occurrences, value stocks had experienced a period of significant outperformance, in part to a high concentration of financial stocks. As the extent of the financial crisis was realised, value gave up all this outperformance.
As alluded to, sector-specific risks were at the centre of these two periods of volatility. Growth indices typically have more technology and consumer discretionary stocks, while value indices tend towards larger, well-established industries such as financials, energy and utilities. In fact, financials make up a quarter of value indices so the outlook for this industry is key in assessing the outlook for a value strategy.
In the decade of recovery following the financial crisis, growth stocks outperformed - most notably in the last two years. Firms are getting more and more of their value from intangible assets, such as intellectual property or strong brands, which do not appear in the financial statements. Disruptive forces are also to blame, with technological and regulatory change expediting the downfall of mature industries, swinging the balance in favour of growing industries.
Economic strength and Volatility
Two factors have been shown to have a significant impact on the performance of these investment approaches. Periods of exceptional economic strength, using manufacturing data as a proxy, lend themselves towards a strong relative performance of value investing. The case made is that out-of-favour companies have tended to recover through times of economic strength, while financials and energy industries benefit from the increased economic activity.
The second factor is volatility. During periods of low volatility, growth stocks have experienced improved relative performance. Markets have been through an extended period of very low volatility in recent years and growth stocks have prospered.
The outlook for the economy at this time is mixed. The probability of the US entering a recession in the next 24 months has increased in the last quarter. Analysts are currently projecting a mean probability of 50% owing to a number of risk factors including the interaction between trade war pressures and US Federal Reserve policy.
Global manufacturing and service PMIs have been weakening, but in contrast, corporate earnings have continued to grow. Unemployment figures are at decade lows and there are signs of wage growth.
In these mixed economic conditions, volatility is expected to increase in the near terms as geopolitical pressures mount. The outlook for value investing from that point of view should be positive. If we see economic conditions strengthening, this should be amplified.
Market consensus has the tendency to drive valuations upwards; however, timing a contrarian view is difficult. Savita Subramanian, Head of US equity at Bank of America Merrill Lynch, raises her concerns: “The prototypical professional investor is likely focused on growth and momentum, thinks Financials are uninvestable, is unused to volatility, and sees valuation as largely irrelevant, but momentum is now expensive, crowded and at risk, Financials are transformed and valuation always matters, eventually."
Regardless of which approach exclusively stands the test of time, in reality, they are best used as complementary strategies in building a well-diversified portfolio. Being committed to any single school of thought can leave a portfolio over-exposed should the strategy unwind.
Disclaimer: The views thoughts and opinions expressed within this article are those of the author and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.