Last Friday was moving day for dozens of stocks as index provider FTSE Russell undertook its annual index reconstitutions. Some companies moved between the small, medium and large-capitalisation categories—all reflecting market movement in the 12 months through early May and its impact on companies’ market capitalisation.[i] There were also shifts within the growth and value world, with several famous growth stocks entering the value index thanks to their falling valuations. For some it was a clean break, whilst others now live in both indexes. In our view, this presents a timely reminder: Growth and value are often judgment calls, in our experience, and we think understanding their qualitative characteristics as well as the more objective criteria can help you delineate between the two investing styles. That could be a critical task moving forward, as we think growth stocks are likely to lead the rebound whenever this year’s stock market negativity reverses.[ii]
Traditionally, growth-orientated stocks represent companies whose returns come from long-term, well, growth—whilst value-orientated stocks’ gains tend to come from investors’ finding and bidding up discounted or undervalued firms. FTSE Russell delineates between the two based on price-to-book ratio, earnings forecasts for the next two years, and a projection of sales growth based on the past five years.[iii] The first of those three seeks to measure value, whilst the latter two measure growth—which is how a company can straddle both styles. MSCI uses the same general approach but with more metrics. On the value side, MSCI adds 12-month forward price-to-earnings ratios and dividend yields, whilst other growth characteristics include short- and long-term forward earnings growth estimates, the long-term historical earnings growth trend and the current internal growth rate, which is an estimate of how much the company could grow by reinvesting earnings and not seeking additional finances.[iv]
Here, too, we find that these criteria—whilst sound—can create significant growth and value overlap. Currently, the MSCI World Value Index has 940 constituents, whilst the MSCI World Growth Index has 805.[v] Yet a whopping 231 constituents are in both indexes, usually weighted as a blend of say, 65% growth and 35% value, 50% each or what have you.[vi] Objectively, they have growth and value characteristics.
Intuitively, we think this makes sense. A company can both have a solid long-term growth outlook and trade at a deep discount. This year, global stocks have endured a downturn that hit traditional bear market territory when measured in US dollars (down -20% or more from a prior high) and hit growth stocks hardest.[vii] That knocked many growth stocks’ valuations, seemingly punching their value index tickets.
Yet that valuation shift doesn’t necessarily correspond with a change to their business models. Many of these companies will likely still aim to capitalise on long-term economic trends. Several will probably still reinvest most of their earnings into their core business in an attempt to expand—growing their footprint within existing markets and branching out into new ones. They will likely continue to invest in research and development, equipment, software and facilities. The large ones still have global reach and strong brand names, in our view. They likely have the clout to seek funding via capital markets, enabling big investments. Many of their earnings have held up relatively well so far.[viii]
That is quite different from a typical value stock’s qualitative characteristics. According to our research, value companies tend to be more cyclical—their earnings fall hard in a recession and bounce fast in the initial recovery, often aided by the steep cost cuts the companies undertook to survive. Later on, as the economy moves out of the recovery phase and into expansion (meaning, output has risen past the prior peak and begun charting new territory), their earnings growth tends to slow as businesses reach the limit of doing more with less and revenue growth becomes earnings’ primary driver. When seeking funding, they typically rely more on bank lending than corporate bond issuance, making them more at risk of losing funding when the yield curve inverts—as we find it usually does heading into a recession. That puts their survival in question, which we think is a big reason why value tends to suffer late in a traditional bear market. Typically, that is when investors indiscriminately sell companies with even a hint of bankruptcy risk, in our experience. But when the new bull market begins, our research shows the surviving value stocks typically bounce disproportionately, pumped up by gutsy bargain-hunters who can fathom a recovery others can’t.
Which brings us to today. So far, whilst this is a bear market in magnitude, it doesn’t have many of the qualitative features we would typically find in a traditional bear market, in our view. The yield curve spread remains wide, not inverted.[ix] (The yield curve is a graphical representation of a single bond issuer’s interest rates across the spectrum of maturities.) Loan growth is accelerating, not contracting.[x] Value stocks are outperforming, and bankruptcy fears appear, for now, largely confined to Silicon Valley’s startup scene.[xi] Unless the economic situation snowballs into a full-fledged recession that triggers value’s normal late-stage suffering, the table doesn’t appear set for value to soar as it often does in a young bull market.[xii]
Hence, in our view, the importance of including qualitative factors into your growth and value determinations. If you go on valuations alone, you risk missing companies with growth-orientated business models that have been hit disproportionately over the past six months. Similarly, if you rely on index classifications to make the judgment for you, then you may end up with diluted exposure—much more than traditional diversification would get you.
For those who aren’t into individual security analysis, we think understanding which sectors and industries tilt more toward growth can help. Our research finds this includes the Information Technology sector, of course, along with the Interactive Media & Services industry within the Communication Services sector. We think Consumer Discretionary is also growth-heavy—especially in the Luxury Goods & Apparel Industry—as are the Health Care Technology, Health Care Equipment & Services and Life Sciences Tools & Services (e.g., medical devices) segments of the Health Care sector. On the value side, we suggest looking toward most of the Financials sector, Energy, Materials, Industrials and Consumer Staples, along with hospital operators, and some Pharmaceuticals.
In our view, investing is often more art than science, and the growth/value divide is a prime example. If you find yourself wishing it were more cut and dry, we are sympathetic. But we think there is a silver lining: With ambiguity comes opportunity to get an edge by interpreting widely known information differently—and ideally more correctly—than the consensus view. Seems to us the current muddling of growth and value is a prime example.
[i] “2022 Russell US Indexes Reconstitution: Summary of Final Changes,” FTSE Russell, as of 30/6/2022. Market capitalisation is a measure of a firm’s size calculated by multiplying its share price by the number of shares outstanding.
[ii] Source: FactSet, as of 1/7/2022. Statement based on MSCI World Index returns in GBP with net dividends.
[iii] Source: “Russell US Style Indexes,” FTSE Russell, as of 24/6/2022. Price-to-book ratios compare a company’s market value with its book value—which is the net value of the company’s assets on its balance sheet.
[iv] “MSCI Global Investable Market Value and Growth Index Methodology,” MSCI, September 2017.
[v] Source: FactSet, as of 24/6/2022. MSCI World Value and Growth Index constituent counts on 23/6/2022.
[vii] Source: FactSet as of 30/6/2022. Statement based on MSCI World, Value and Growth Index returns with net dividends in USD, 31/12/2021 – 29/6/2022. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
[viii] Ibid. Statement based on Earnings Scorecard, MSCI World Growth Index.
[ix] Ibid. Statement based on 10-year and 3-month government bond yields in the US, UK, Germany, France and Japan, 29/6/2022.
[x] Source: Federal Reserve, European Central Bank, Bank of Japan and Bank of England, as of 13/6/2022.
[xi] Source: FactSet, as of 1/7/2022. Statement based on MSCI World Value and Growth Index returns with net dividends in GBP.
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