Is it time to add 'value'?

In the current economic climate, this has placed value stocks at a significant disadvantage at a time when investors have valued share buybacks.

It is often said that “East versus West, Seabiscuit versus War Admiral, Kansas City versus Memphis-style barbecue – history, sports and culture are filled with long-standing rivalries and reversals of fortune”. Such ebbs and flows can also apply to the dynamics of investments and specifically those of growth and value stocks. The very existence of the growth versus value paradigm is a long-debated topic on Wall Street.

History shows us that in general, growth stocks have the potential to perform better when the interest rates are falling and company earnings are rising. However, they may also be the first to be punished when the economy is cooling. Value stocks, often stocks of cyclical industries, may do well early in an economic recovery but are typically more likely to lag in a sustained bull market. In a September 2020 research paper, Evercore ISI’s Macro Research Analyst Dennis Debusschere noted that the 2020 rotation isn’t about growth versus value, rather it is about “Quarantine versus Recovery and Defensives versus Cyclicals”. Due to their cyclicality, value sectors usually coincide with an economic upswing, such as we have already seen.

I’m too embarrassed to ask – What are growth and value investing?

Growth investing is one of the two fundamental approaches in stock investing. Growth stocks represent companies that have demonstrated better-than-average gains in earnings in recent years and that are expected to continue delivering high levels of profit growth, although there are no guarantees. “Emerging” growth companies are those that have the potential to achieve high earnings growth but have not established a history of strong earnings growth.

Value is the other fundamental approach in stock investing. Value investor stocks appear to be undervalued in the marketplace. Value fund managers look for companies that have fallen out of favour but still have good fundamentals. The idea behind value investing is that stocks of good companies will bounce back in time if and when the true value is recognised by other investors. Value investing has a long and illustrious history, championed by none other than Benjamin Graham (author of the book “The Intelligent Investor”, the man who arguably invented scientific stock analysis in the 1930s and played a significant role in shaping Buffett’s career and investment philosophy.

The last 10 years have been marked by several unique features that have turned value on its head. The most notable ones being the prolonged period of slow economic growth following the Global Financial Crisis (GFC) and coronavirus recession. This highly unusual period has radically altered the environment for value stocks. For instance, the abnormally slow recovery in the aftermath of the GFC has meant that the normal “sweet spot” for value, when company earnings rebound after an economic downturn, has been insipid, to say the least. IMF analysts say that among the economies that experienced a banking crisis in 2007-08, about 85% are still operating at output levels below precrisis trends. The relative scarcity of earnings growth has also magnified investors’ interest in growth stocks, which are perceived to offer more earnings certainty. This trend has been focused in a handful of tech companies, notably the so-called “FAANG” stocks – Facebook, Apple, Amazon, Netflix and Google (Alphabet). The year-to-date gains for the “FAANG” stocks are impressive. Towards the end of 2020, Apple was leading the way, up by more than 85%, but Amazon and Netflix weren’t too behind Apple. In contrast, value stocks, whose earnings are generally more exposed to economic downturns, have been shunned.

Aggressive central bank intervention following both GFC and coronavirus recession has not helped either. This has had the effect of reducing interest rates to historic lows, which has tended to favour growth stocks. Their profits, seen as stretching out into the distant future, are more highly valued by the stock market in these circumstances than when rates are high. Falling interest rates have therefore benefited them far more than value stocks in the recent economic environment. Lower interest rates lower the discount rate and so future earnings become worth more in today’s money. This is in contrast to value stocks, where low-interest rates don’t help to the same extent. At a lower valuation, much of a value firm’s profits typically are expected in the next several years, rather than pushed out across decades as growth stocks are.

Since value stocks are typically more cyclical businesses, they tend to have less capacity to return cash to shareholders during bad economic times than growth stocks. In the current economic climate, this has placed value stocks at a significant disadvantage at a time when investors have valued share buybacks. However, many of these headwinds for value are dying down or reversing. Economic growth is finally picking up, interest rates are rising and buyback activity seems to have peaked.

Although nothing is guaranteed, a market rotation in favour of value seems increasingly likely over the coming years. Furthermore, the valuation difference between value and growth stocks is at its widest level in many years. In the past, differences of this magnitude have heralded significant value outperformance over subsequent years, although past performance is not a guide to future performance. The biggest rewards can come from being brave during the scariest times. For the investors willing to ride out the turbulent times, the potential rewards will be considerable once the tide turns.