What categories of equities are doing best lately? That is a question with multiple answers, some easier to understand than others, in our experience. Saying US shares are beating Europe and Asia seems intuitive. So is saying Tech and Communication Services are amongst the best sectors. But, based on our interactions with investors over the years, when the conversation shifts to growth beating value, many investors’ brows furrow. We are here to help with that, as we think the value and growth distinction is especially important to returns in 2021. Understanding what makes a share growth versus value can help investors understand why certain categories have led since lockdowns—and will probably keep doing so for the rest of this bull market, in our view.
Through Wednesday’s close, global shares have more than doubled since last year’s 16 March bear market low.[i] (A bear market is a typically long, fundamentally driven, broad market decline exceeding -20%.) But doing that well—or better—required emphasising the right kind of companies. Since this young bull market began, global value shares have risen 52.1%, whilst global growth is leading the charge at 85.2%.[ii] Lest you think owning only growth shares and ignoring value would have been an easy path to big returns, however, there have been several countertrends along the way where value led—testing investors’ mettle. In our experience, many investors are tempted to chase whatever category is doing best in the recent past, which could have lured many to swap a growth emphasis for value. The most notable countertrend occurred late last year and early this year, tied to enthusiasm over COVID vaccines and widespread expectations of swift reopenings launching a new Roaring Twenties-style boom of lasting, fast economic growth. By Q1’s end, we saw many commentators globally claiming value would lead for a long while, which could have led many investors to follow their forecast. Yet from mid-May onward, growth crushed value 19.9% to 4.2%, and we think it is likely to stay in the driver’s seat for the rest of this bull market.[iii] (A bull market is a long period of overall rising equity prices.)
To understand why, it helps to understand what growth and value entail and when each category usually does best, according to our research. Value shares, as the name implies, are generally valued more cheaply relative to their underlying assets and earnings potential than growth shares (which we will get to shortly). In our experience, they typically have lower valuations, which are metrics comparing prices to various fundamental measures like price-to-earnings ratios, price-to-book, price-to-sales, etc., that many investors use to gauge whether share prices are expensive or cheap. Value shares often return more of their earnings to shareholders via dividends and share buybacks, investing less in long-term endeavours, according to our findings, and their profits tend to be highly sensitive to economic trends.
Overall, we find value firms tend to have lower credit quality and borrow primarily from banks, not capital markets. As a result, our historical research shows value firms typically lead early in economic cycles, tied to this cyclical pattern: Value shares often get hit hard during bear markets, as yield curves invert (short-term gilt yields exceed long-term gilt yields). Banks’ principal business model is borrowing short term to fund long-term lending, so inverted yield curves hurt loan profits and discourage lending, starving value companies of capital at the time their sales are tanking. Investors, cognisant of value’s heightened bankruptcy risk and fuelled by bear market panic, tend to punish the category indiscriminately. Inevitably the panic overshoots, creating a huge gap between reality and expectations. Accordingly, we find value usually rises disproportionately in a bull market’s initial rebound. This is also when value companies’ earnings growth is usually strongest, in our experience, as all the cost cuts they made to stay afloat during the recession turn modest revenue growth into easy profits.
By contrast, we find growth shares generally heavily reinvest profits in the business instead of paying high dividends, driving and capitalising on innovation and long-term technological trends. We also find investors are usually willing to pay more for future earnings in exchange for this long-term potential, so growth shares often trade at higher valuations. Because their earnings growth comes from expansion and long-term trends, we think they are generally less sensitive to expected economic growth rates. Compared to value shares, we think their earnings and revenues are generally more stable, and they boast fat gross profit margins (gross margins are sales minus costs, divided by sales, normally expressed as a percentage). Growth companies also tend to have high-quality features like familiar brand names, strong management teams, diverse product lines and global revenue streams, according to our research. Accordingly, our analysis shows they tend to outperform later in the economic cycle, when economic growth often slows and value firms no longer have easy profits from cost cuts. At this point, we think revenue growth becomes the main driver of earnings growth, favouring growth shares.
Since value shares lead in the early stages of economic recoveries, many commentators we follow thought value would lead for a long while once vaccines kicked in after the pandemic—they figured COVID uncertainty had merely delayed value’s typical early-bull market rally. In our view, they overlooked a key factor: Last year’s bear market was too fast to reset the growth/value cycle. Our historical research shows bear markets normally have long rolling tops—early declines are gradual and mild, with the worst declines usually coming after several months (or more). Since global data begin in 1969, bear markets have averaged 15.5 months, on average.[iv] The 2020 bear market lasted just 23 calendar days.[v] We don’t think that was nearly long enough for value shares to suffer their typical late-bear market punishing. The downturn ended before that indiscriminate selling happened, in our view.
Additionally, we think the credit cycle failed to reset. Typically, as expansions mature and inflation heats up, central banks attempt to fight it by raising short-term rates. Eventually they overshoot, inverting the yield curve, leading to the credit crunch that usually causes the ensuing recession, in our experience. That wasn’t the case this time. Yes, the global yield curve inverted briefly in 2019, but barely—and it flipped positive again later in the year.[vi] Additionally, we think lockdowns caused 2020’s bear market, not a credit crunch. Plus, an alphabet soup of government and monetary authority programs kept loans flowing to value firms.
Accordingly, the conditions normally favouring value early in bull markets never arrived in 2020, in our view. Instead, growth led in the run up to, during and after the bear market.[vii] Therefore, in our view, equity markets are behaving as if this is a late-stage bull market rather than an early bull market. Slowing economic growth also supports growth shares, which we think explains why value fizzled as Roaring Twenties chatter died out. In our view, growth shares probably keep leading until this bull market runs its course, with value’s time in the spotlight not likely to arrive until after the next bear market, whenever that occurs.
So where can you find growth shares now? As it happens, growth and value tend to cluster in different sectors. Growth dominates Tech and Consumer Discretionary. Financials, Industrials, Energy and Consumer Staples are value-heavy. Other sectors—like Health Care and Communication Services—include a mix of both value and growth. For example, part of Communication Services is the old Telecom sector, which is value. But the Interactive Media & Services industry, home to several large Internet companies, is growth-heavy. In the Health Care sector, Health Care Technology, Health Care Equipment & Services and Life Sciences Tools & Services (e.g., medical devices), and some Biotechnology companies fall into the growth camp, whilst hospital operators lean towards value and Pharmaceuticals are mixed.
Adding nuance, some value shares are defensive and others are offensive. Defensive value shares are companies whose demand doesn’t change much when the economy is in a downswing, driving investors to them during bear markets and recessions. Utilities and Consumer Staples are examples—even when times are tough, people still turn on the heat and go to the grocery store. Our research shows these sectors don’t necessarily rise during bear markets, but they generally take a much milder beating.
Offensive value shares tend to have more economic sensitivity in our view, and, depending on the fundamental drivers for each sector, can generate opportunities even late in a bull market—making them good targets to diversify a growth-orientated portfolio. This category includes Energy, Industrials and some Financials.
No style is permanently superior, nor do we think investors benefit from focusing exclusively on growth or value—concentrating portfolios in one area can increase risk. But we think identifying leadership trends between value and growth can help capitalise on opportunities you might otherwise miss at various points in the market cycle.
[i] Source: FactSet, as of 8/9/2021. MSCI World Index with net dividends, 20/2/2020 – 16/3/2020.
[ii] Source: FactSet, as of 8/9/2021. MSCI World Growth and Value Indexes with net dividends, 16/3/2020 – 7/9/2021.
[iii] Source: FactSet, as of 8/9/2021. MSCI World Growth and Value Indexes with net dividends, 13/5/2021 – 7/9/2021.
[iv] Source: FactSet, as of 8/9/2021. Bear market dating is based on the MSCI World Index price level in GBP, 31/12/1969 – 8/9/2021. Data prior to 1980 are monthly, daily thereafter. For this analysis, 30.5 days is a month.
[v] Ibid. 20/2/2020 – 16/3/2020.
[vi] Source: FactSet, as of 8/9/2021. Statement refers to the GDP-weighted yield curve using interest rates from 23 developed world nations.
[vii] Source: FactSet, as of 8/9/2021. Statement based on MSCI World Growth and Value Indexes, 31/12/2019 – 8/9/2021.
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