Growth? Value? Digging Into Style Definitions

Last Friday was moving day for dozens of stocks as FTSE Russell undertook its annual index reconstitutions. Some companies moved between the small, medium and large-cap categories—all reflecting market movement in the 12 months through early May and its impact on companies’ market capitalization. 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, while others now live in both indexes. In our view, this presents a timely reminder: Growth and value are often judgment calls, and understanding their qualitative characteristics as well as the more objective criteria can help you delineate between the two investing styles. That will be a critical task moving forward, as we think growth stocks are likely to lead the rebound whenever this year’s bear market ends.

Traditionally, growth stocks represent companies whose returns come from long-term, well, growth—while value 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.^[i] The first of those three seeks to measure value, while 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, while 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.^[ii]

Here, too, these criteria—while sound—can create significant growth and value overlap. Currently, the MSCI World Value Index has 940 constituents, while the MSCI World Growth Index has 805.^[iii] 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.^[iv] Objectively, they have growth and value characteristics.

Intuitively, 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 (down -20% or more from a prior high) and hit growth stocks hardest. That knocked many growth stocks’ valuations, punching their value index tickets.

Yet that valuation shift doesn’t necessarily correspond with a change to their business models. They still aim to capitalize on long-term economic trends. Many of these companies 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 invest in research and development, equipment, software and facilities. The large ones still have global reach and strong brand names. They have the clout to seek funding via capital markets, enabling big investments. Many of their earnings have held up relatively well so far.

That is quite different from a typical value stock’s qualitative characteristics. 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, 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 rely more on bank lending than corporate bond issuance, making them more at risk of losing funding when the yield curve inverts—as it usually does heading into a recession. That puts their survival in question, which is a big reason value tends to get pounded late in a traditional bear market. Typically, that is when investors indiscriminately sell companies with even a hint of bankruptcy risk. But when the new bull market begins, 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, while this is a bear market in magnitude, it doesn’t have many of the qualitative features we would expect in a traditional bear market. The yield curve has steepened, not inverted. Loan growth is accelerating, not contracting. Value stocks are outperforming, and bankruptcy fears are, for now, largely confined to Silicon Valley’s startup scene. Unless the economic situation snowballs into a full-fledged recession that triggers value’s normal late-stage pounding, the table doesn’t appear set for value to soar as it normally does in a young bull market.

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-oriented 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, understanding which sectors and industries tilt more toward growth can help. That includes the Information Technology sector, of course, along with the Interactive Media & Services industry within the Communication Services sector. 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 have most of the Financials sector, Energy, Materials, Industrials and Consumer Staples, along with hospital operators, and some Pharmaceuticals.

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 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 opportunity.