In a low growth world, companies that can reliably grow their earnings and dividends have been rightly prized by investors. However, the premium placed on this growth has grown increasingly high and the past three months have seen some change of leadership in stocks markets, with more economically sensitive areas starting to recover from very low valuations. Does this herald a turning point for ‘value’ strategies?
The extent to which ‘value’ stocks have underperformed growth should not be underestimated: The FTSE World Growth index has outperformed the FTSE World Value index over one, three and five years. The terms are not perfect – there is overlap between the indices, for example – but it is indicative of a strong trend.
Value managers are starting to put their heads above the parapet. Ben Whitmore, manager of the Silver-Rated Jupiter UK Special Situations fund and head of strategy for UK Value at the group, said: “The dispersion in valuations between value and growth stocks is at its widest for 45 years. If an investor isn’t going to be a value investor now, they are never going to be one. Value needs to outperform by 40-50% to catch up. We believe there is a value premium over time and there should be some adjustment.”
Stretched Valuations on Growth Stocks
He is not the only one bemoaning this anomaly. The UK Equity income team at JO Hambro Capital Management recently commented: “The crowding into growth and defensive stocks has created stretched valuations in this part of the market, with the latter exacerbated by low interest rates, the desire by asset allocators for low volatile outcomes and behavioural psychology.
“There are currently two stock markets in one: defensive growth, bond proxy-type stocks are in the ascendency and highly valued, while the cyclical sectors, anything financial related and all small caps are all unloved and are where the value in the market resides.”
The question for investors is whether value stocks will revert back to the long-term average. Investors have been saying for some time that ‘dependable growth’ companies look over-valued, but the anomaly has persisted as economic growth has been elusive. However, in the past couple of months, there has been some reappraisal.
Gary Potter, co-head of the BMO Global Asset Management multi-manager team, says: “The valuation of growth stocks, particularly the FANG stocks (Facebook (FB), Amazon (AMZN), Netflix (NFLX), Alphabet (GOOGL)) became quite excessive towards the end of last year. They were growing at significantly faster rates and in a low inflation environment, that growth is accorded a much higher rating.
Short Term Performance of Value-Orientated Funds
“That said, the elastic can only get stretched so far because there is a re-evaluation and growth has given back some relative performance in recent months.” Over the very short-term this has meant better times for funds with a value tilt, such as Schroder Recovery (3rd in the UK All Companies sector over six months) or Jupiter UK Special Situations.
However, Potter believes that for value to outperform sustainably, there still needs to be greater confidence in economic recovery. He gives the example of Amazon, versus a chemical company: “The chemical company may be cheap, but it needs economic activity to justify a higher value or it becomes a value trap. I don’t think we are at the start of a meaningful correction.”
This is largely because the ‘low growth, low inflation’ to which markets have become accustomed shows no sign of dissipating. James Klemster, head of portfolio management at Momentum GIM, says: “This is a low growth environment. Stock markets have relied on earnings growth and multiple expansion, but this has petered out somewhat. They are now reliant on earnings growth to keep markets ticking over.”
To date, ‘value’ stocks have not had the earnings growth to justify a higher rating. Also, interest rate rises have been pushed further out, which has supported the high valuations of growth stocks.
Making the Most of Growth and Value Strategies
Potter has readjusted his portfolios a little to take advantage of the very low valuations of traditional value companies, but only be a few per cent here and there, and has clawed some of it back following the recent recovery in value. Klempster is also retaining both in his portfolios: “We use both value and growth in our portfolios, believing they have complementary drivers. However, value has underperformed and, from a contrarian point of view, that would seem to be an interesting place to look.”
Potter also points out that the outperformance of growth has not been a universal phenomenon. While it has applied in markets such as the UK, US and Europe, the reverse has been true in Japan; in emerging markets, the effect has been largely neutral.
Markets may be starting to reappraise value strategies, but it is likely to be tentative and subject to set-backs as self-sustaining economic growth remains elusive. A wholesale reversion to value seems unlikely for the time being as markets contend with a potential Brexit and the US election. However, if economic growth does start to re-emerge, value has a long way to bounce.
