For some time, growth companies have been outperforming their value counterparts – and the trend has been exacerbated by the coronavirus pandemic.
To date, the pattern has been in place for 13 years, costing US value investors a whopping 185%¹ versus their growth equivalents. In early 2020, with the worldwide spread of Covid-19, the trend has accelerated further. Many value investors have been left scratching their heads, others are running for the door and some value fund managers are admitting defeat. Should value investors hold their nerve during these unprecedented times?
Typically, trends revert to the mean over the course of a cycle. The differential between a growth and value company cannot continue to widen indefinitely. There are three main reasons why the prevailing market backdrop has been supportive for growth companies. First, the more scarce growth has become, the more investors have been prepared to pay for it. Second, the falling interest rate environment has resulted in investors’ willingness to pay up for long-term growth. Third, monetary stimulus has boosted asset prices to inflated levels – so much so that investors no longer care about valuation.
The current dominance of Covid-19 makes value companies – such as those in the travel, leisure, energy and banking sectors – look very unattractive. It is worth asking whether during these unprecedented times, value companies are more unappealing relative to history?
In a recent paper, Cliff Asness addresses this commonly raised question by assessing the quality and gross profitability of value companies compared to growth companies relative to history. In doing so, Asness demonstrates that the net-debt to equity of a value company is lower than its historical average and less than a growth company. He also shows that gross profitability is ahead of longer-term trends compared to a growth company. There is therefore nothing fundamentally broken about value companies relative to history. Over the long term, their attractive valuations should be recognised by the market. Investors just need to be patient enough to realise the inherent value of these companies.
We must also consider the dominance of some growth companies, particularly in the US, where five companies make up over 21% of the S&P 500. This is even starker than at the peak of the dot.com boom in 1999, when the top five companies represented 18% of the Index. At this time investors were extrapolating the strong performance of growth companies into the future with no expectation of a reversal in favour of value companies. It is interesting to note what happened subsequently: between 1 January 2000 and 31 January 2007, growth stocks fell 19%, while those once-unloved value stocks rose 47%. This represents an outperformance of 66%.
We could assume that the monopolistic nature of the largest five companies of the S&P 500 will allow them to continue to grow indefinitely, outpacing and dominating any competitors. But on the other hand, we can also question at what point the anti-trust regulators and tax authorities will step in to control their dominance and take an increasing share of their profits in tax.
Furthermore, investors should consider whether a change in market dynamics could result in a reversal in the fortunes of growth and value companies. A glimmer of evidence that Covid-19 is becoming less of a threat will likely kick-start a chain reaction: a pickup in activity; an improvement in growth and hence an increase in bond yields from historic lows; a potential increase in inflation expectations; a recovery in the oil price – the list goes on. A recovery outlook will take shape, a perfect backdrop for value companies which typically do well in such a situation where companies may be generating, or are about to generate, strong earnings growth.
It may be puzzling to some that value has lagged the broader market recovery since the March lows, but investors are waiting for confirmation of a sustained economic recovery, which is almost impossible while the uncertainties surrounding Covid-19 continue to dominate. In the meantime, they continue to play it safe with quality growth companies.
Recently, however, we have seen some evidence of how quickly markets react to an improving outlook. The S&P US Value outpaced the S&P US Growth by 4% in the first eight days in June, giving value investors some hope that a reversal will come once a clear path to recovery is evident. Historical evidence suggests value investors should indeed hold their nerve and for those growth investors, who have done so well over the last 13 years, perhaps now is the time to start dipping their toe into those less-frequented value waters.