Is it time for a value comeback?

Fri 09 Nov 2018

In recent years value investors in the US have watched as growth stocks have soared and provided excellent returns to shareholders. Some investors have even begun to call value investing a “dead strategy”.

There are two primary schools of thought when it comes to effective stock selection: value and growth investing. There are probably as many definitions of these two styles as there are fund managers, but there are a few shared characteristics that most agree on:

Investors looking for a return through a value stock often do so through one of three channels:

• • buying stocks that are relatively cheap which can be measured by a ratio such as the P/E price-to-earnings ratio, and looking for a mean reversion of valuations,
  • buying a stock that has been completely oversold and hence might be valued too low as investors are too negative and gloomy on its future prospects (a “deep value” selection),
  • or the investor might buy a company which has the potential to improve its profitability or attractiveness by other means such as reducing costs or paying a dividend if it had not previously.

Whatever the approach, value investors generally end up buying stocks which are cheaper than the market average.

For growth stocks the underlying investment hypothesis for the stock selection is slightly different. As the name suggests, the growth investor buys companies that are growing rapidly or are likely to grow a lot faster than the market expects. Often, growth stock investors will focus on top line revenue as opposed to bottom line net income growth, as the bottom line is often not a great reflection of the success and future prospects of the company. Take technology titan Amazon. For many years the company was not even profitable. But as CEO and founder Jeff Bezos eloquently put it, Amazon is a high fixed initial cost business. Now it has set up its distribution network and AWS technology it will reap benefits for decades to come. The top line growth showed this and Amazon shareholders were rewarded handsomely. Often the fastest growing companies with great pricing power or patented technology (Did you know Amazon has a patent for the 1 click buy button online?) are expensive on a P/E basis. Why? Because the earnings are expected to grow!

For now let’s define value stocks as low P/E and growth stocks as high P/E and use this to guide our analysis.

Every bull market is unique and driven by a different set of factors. Post GFC we saw a strong rebound in value stocks as cheap money and liquidity provided the conditions for a junk rally. Value outperformed growth in the first year of the GFC recovery.

As the Fed continues to hike rates, trade wars escalate and unemployment in the US remains at multi-decade lows (the Philips Curve would suggest an inflation pick up) we appear to be late in the cycle and favourable conditions for growth may soon leave us. Furthermore, with hot technology stocks such as Apple or Amazon that for a long time would be considered great growth plays soaring to trillion dollar market caps there is also a behavioural aspect typical of late cycle that is at work here. FOMO. Or “Fear of missing out”. Investors start to believe that returns yesterday mean returns today and the Bull Run will never end. They decide to throw money at a tech or growth fund too. Sadly, exactly at the wrong time. Just as quickly as investors pile into high growth stocks through mutual funds, ETFs or individual security selection, they get out of these investments when markets turn south. In the recent mid-October correction the NASDAQ index, which is comprised of many high growth stocks, fell more than the S&P500.

To conclude, as conditions appear less favourable in the US as expansionary fiscal policy through tax cuts dissipates and interest rates rise further, investors will be incentivised to move into more defensive stocks that have stable earnings as excessive valuations no longer hold up. A mean reversion strategy suggests growth may have had its day and value stocks could outperform, but if projected economic conditions change growth could continue its dominance. This difference in return profiles depending on economic conditions enables the active manager to add great value to an equity portfolio by buying into weakness and selling on strength, and subsequently achieve higher risk-adjusted returns over the long term.

Daniel Gorringe