Value and Growth Equity Strategies: The Magic is in the Mix
The long-term case for value and growth equity investment strategies are both based on sound fundamental principles. The basic premise of value investing is that investors are rewarded by emphasizing stocks trading at discounted prices relative to the market, much in the same way high yield bond investors are rewarded through incremental yield premiums for accepting a higher degree of credit risk. Conversely, the premise of growth investing is that investors will be rewarded by skewing portfolios to companies and industries undergoing above average growth in earnings and intrinsic net worth. Nonetheless, investors should exercise caution and recognize that simplistic measures of growth and value styles have potential shortcomings, and should not be viewed in isolation. In general, we find that the magic is in the mix for value and growth investors alike.
A value orientation is often best rewarded following periods of economic difficulty. The movement from “awful” to “merely bad” represents an important source of fundamental change. Somewhat counter-intuitively, often the best environment for growth investing is when overall growth is scarce, as has been the case during much of the past three years. This is where the mix comes in, namely with value disciplines that look beyond price alone to identify pockets of discounted valuation coupled with a degree of positive change, and growth strategies that incorporate an element of price discipline.
Market conditions over the past three years highlight some of the potential pitfalls of overly simplistic measures of growth and value. Using the MSCI World Growth and Value style indices as a proxy, we note that style dynamics have been a relatively one-sided affair over the three years ending December 2015, with the growth index handily outpacing the value counterpart by registering cumulative total returns of 40.2%, and in comparison, 27.6% for the value index. Much of that differential can be attributed to the prevailing relative sector composition of the two benchmarks.
The MSCI World Value Index has been dominated by two primary groups of stocks. The first being somewhat lower-volatility, higher-yielding sectors, particularly telecommunications and utilities as well as financial services companies. Historically, these types of companies have tended to fare well in challenging markets, but that has not been the case in the era of ultralow and negative interest rates, particularly with an uncertain path ahead for the U.S. Federal Reserve (Fed) rate action. The other segment is comprised of mature, deep cyclical stocks, and most notably in recent years, the beleaguered energy and materials sectors. Recall many of these commodity-linked companies were classified as growth as recently as 2011.
As noted, growth style investing tends to fare relatively well when growth is hard to come by and possesses a larger allocation to “self-help” earnings growers, which are represented within the consumer, healthcare, and information technology sectors. In a very basic sense, much of the outperformance of growth, particularly in the past year, has simply reflected sector composition. The growth universe has clearly benefitted from its larger exposure to consumer, technology, and healthcare; and has simultaneously benefitted from the lower exposure to energy and materials (and of course also lowers weights to financials, telecommunications, and utilities).
When looking at trailing three-year returns ending December 31st, 2015, sector disparities are stark. Healthcare, technology, and consumer discretionary have topped the league tables advancing 74%, 57%, and 55%, respectively, a significant catalyst to the growth oriented indices. On the other hand, commodity-oriented sectors of energy and materials have declined by 17% and 16%, respectively, while the bond-like sector of utilities saw a rise of 23%. (For reference the MSCI World Index overall is up 34% in U.S. dollar terms).
On the heels of such sharp style differentials, just as it seems many investors have begun to question the basic premise of value investing, 2016 has witnessed a stark reversal of leadership. Consistent with the theme of “less-bad” thus far in 2016, we have witnessed an outsized rally in the previously shunned commodity-oriented stocks. Alternatively, after significant outperformance, investor sentiment toward high-growth, high-momentum stocks has moderated. Volatile losers within the energy sector have been at the peak of the recent turnaround but valuations have not been the only catalyst. From a macro perspective, stabilization is being seen in commodity prices while a pickup in rhetoric from OPEC has brought about a potential relief in the supply glut that has been witnessed. Furthermore, skepticism has surfaced over the commencing of the Fed’s rate hike path which has had markets reeling as recent conditions have become less supportive for growth. This has been hindered by tightening financial conditions leading to a decline in the U.S. dollar and Treasury bond yields, both supportive for oil prices and value.
The aforementioned events coupled with fundamental changes at a company level have led to capitulation amongst investors seeking out beaten-down energy stocks. Through March 4th, 2016, the MSCI World Value Index has returned -2.1% while the MSCI World Growth Index has declined by -3.9%. However, the overall returns do not depict the whole story when taking a more granular look, the energy sector has risen by 7% in the growth-style index while the healthcare sector has returned -9%, a significant spread of 16% in just over three months. While we are by no means forecasting a fundamental shift from growth to value, things seem to be less-bad for commodity-oriented companies and valuations are in favor; MSCI World Value has a price-to-earnings ratio (P/E) of 14.5x and MSCI World Growth has 18.7x P/E. Fundamentals still remain tough, but dividend and capital expenditure cuts, a potential troughing in commodity prices, and attractive valuations are leading investors to rethink their positioning. However, in the end it’s all about earnings growth as well as upside to estimates. Catalysts are still lacking on this front for many stocks within the commodity suite but the situation is improving and capitulation can result in swift movement in prices.
Another important consideration in evaluating simplistic measures of growth and value is the propensity for high concentration in sector weightings amid speculative excesses in the markets. When looking over the past 20 years, both styles have fallen victim to significantly higher weightings in single sectors as shown below. For value, it was the 40% in financials leading up to the financial crisis; whereas in growth, it was the technology weighting of 35% (and approaching 50% inclusive of high growth telecommunication and biotech) amid the late 1990s tech bubble. An overcrowded trade can quickly wipe out gains if not monitored.
As noted previously, value and growth should not be viewed in isolation. We believe the magic is in the mix. Indeed over time we seek to deliver highly consistent portfolio profiles that consciously avoid the excessively valued, highly volatile “glamour” stocks, which are often priced for perfection and under-estimate competitive forces in the market. Despite the challenging macro environment for growth, uncertain and divergent global monetary policies, and the continuing era of low-to-negative interest rates, maintaining a degree of balance between growth and value disciplines is a more reliable and repeatable approach than the more extreme and simplistic style metrics. As always, we find bottom-up, company-by-company, analysis of fundamental change, earnings trends, and relative valuations to be a much more reliable guide than any sort of top-down forecasts.