What categories of stocks are doing best lately? That is a question with multiple answers, some easier to understand than others. Saying US stocks are beating Europe and Asia is intuitive. So is saying Tech and Communication Services are among the best sectors. But when the conversation shifts to growth beating value, many investors’ brows inevitably 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 stock 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 stocks have more than doubled since last year’s March 23 bear market low. But doing that well—or better—required emphasizing the right kind of companies. Since this young bull market began, global value stocks have risen 85.7%, while global growth is leading the charge at 115.5%.[i] Lest you think owning only growth stocks 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. The most notable countertrend occurred late last year and early this year, tied to enthusiasm over COVID vaccines and widespread expectations of swift reopenings kicking off a new “Roaring Twenties” of lasting, hot economic growth. By Q1’s end, pundits globally claimed value would lead for a long while, and investors left and right wanted to jump on the bandwagon. Yet from mid-May onward, growth crushed value 16.9% to 2.4%, and we think it is likely to stay in the driver’s seat for the rest of this bull market.[ii]
To understand why, it helps to understand what growth and value entail and when each category usually does best. Value stocks, as the name implies, are generally valued more cheaply relative to their underlying assets and earnings potential than growth stocks (which we will get to shortly). They typically have lower valuations (price-to-earnings, price-to-book, price-to-sales, etc.) and return more of their earnings to shareholders via dividends and stock buybacks, investing less in long-term endeavors. Their profits are highly sensitive to economic trends. Overall, they tend to have lower credit quality and borrow primarily from banks, not capital markets. As a result, they often get hit hard during bear markets, as inverted yield curves lead banks to rein in credit, starving these companies of capital at the precise time their sales are tanking. Investors, cognizant of value’s heightened bankruptcy risk and fueled by bear market panic, normally punish the category indiscriminately. Inevitably the panic overshoots, creating a huge gap between reality and expectations. Accordingly, value usually rises disproportionately in a bull market’s initial rebound. This is also when value companies’ earnings growth is usually strongest, as all the cost cuts they made to stay afloat during the recession turn modest revenue growth into easy profits.
By contrast, growth stocks generally heavily reinvest profits in the business instead of paying high dividends, driving and capitalizing on innovation and long-term technological trends. Investors are usually willing to pay more for future earnings in exchange for this long-term potential, so growth stocks often trade at higher valuations. Because their earnings growth comes from expansion and long-term trends, they are generally less sensitive to expected economic growth rates. Compared to value stocks, their earnings and revenues are generally more stable, and they boast fat gross profit margins. Growth companies also tend to have high-quality features like familiar brand names, strong management teams, diverse product lines and global revenue streams. Accordingly, 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, revenue growth becomes the main driver of earnings growth, favoring growth stocks.
Since value stocks lead in the early stages of economic recoveries, many pundits 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. Typical bear markets 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 16.3 months, on average.[iii] The 2020 bear market lasted just 39 calendar days.[iv] That wasn’t nearly long enough for value stocks to suffer their typical late-bear market punishing. The downturn ended before that indiscriminate selling happened.
Additionally, the credit cycle didn’t 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. That wasn’t the case this time. Yes, the yield curve inverted in 2019, but it flipped positive again later in the year, and a credit crunch didn’t cause 2020’s bear market. Lockdowns did. Plus, an alphabet soup of Federal Reserve programs kept loans flowing to value stocks.
Accordingly, the conditions normally favoring value early in bull markets never arrived in 2020. Instead, growth led in the run up to, during and after the bear market. Therefore, in our view, stocks are behaving as if this is a late-stage bull market rather than an early bull market. Slowing economic growth also supports growth, which we think explains why value fizzled as “Roaring Twenties” chatter died out. In our view, growth stocks 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 stocks now? As it happens, growth and value tend to cluster in different sectors. Growth stocks dominate Tech and Consumer Discretionary. Financials, Industrials, Energy and Consumer Staples are value-dominated. 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, while hospital operators lean towards value and Pharmaceuticals are mixed.
Adding nuance, some value stocks are defensive and others are offensive. Defensive value stocks 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. These sectors don’t necessarily rise during bear markets, but they generally take a much milder beating.
Offensive value stocks tend to have more economic sensitivity 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-oriented portfolio. This category includes Energy, Industrials and some Financials.
No style is permanently superior, nor should investors focus exclusively on growth or value—concentrating portfolios in one area increases risk. But identifying leadership trends between value and growth can help capitalize on opportunities you might otherwise miss at various points in the market cycle.
[ii] Source: FactSet, as of 9/1/2021. MSCI World Growth and Value Index returns with net dividends, 5/13/2021 – 9/1/2021.
[iii] Source: FactSet, as of 9/3/2021. Average MSCI World Index bear market duration, 12/31/1969 – 9/3/2021. Data before 1980 are monthly; daily thereafter. A month is defined as 30.5 days.
[iv] Source: FactSet, as of 9/3/2021. MSCI World Index bear market, 2/12/2020 – 3/23/2020.
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