Over the last decade or so, the classic value versus growth investing debate has been fairly one-sided. Growth, buoyed by a prolonged period of low interest rates, has considerably outperformed value, as investors increasingly looked for companies with strong earnings potential, and overlooked those that appeared cheap today. However, there are some tentative signs that conditions are now changing in value’s favour. We believe that it might be time for investors to reconsider this unloved part of the market.
History demonstrates that value investing is a successful investment approach over the long term. Only in extreme, artificially low interest rate environments has growth been able to have a prolonged period of outperformance. Even including this recent period of supernormal growth returns, the MSCI World Value Index has outperformed the MSCI World Growth Index over the last half century.
This relationship between interest rates and returns to investment style exists because of how stocks are valued in discount cash flow models. When interest rates are normal, the discount rate applied to future earnings in equity valuation models is higher than when rates are zero, and hence investors assign a reduced present value for future earnings. Growth stocks are typically characterised by having strong, rising future earnings, therefore much of their valuation is derived from the potential of capturing those future earnings. During a normal interest rate environment, those future earnings are valued lower today.
Current macroeconomic backdrop is supportive for value
In a world where the cost of capital was negative, a rising tide lifted all boats, and falling interest rates lifted all growth stocks. Today, the macroeconomic environment has turned in value’s favour. Higher inflation and higher interest rates mean investors are once again assigning greater value to cash flow and earnings today, which are plentiful in the value cohort of stocks.
Provided interest rates don’t settle back below 1%, a scenario that is unlikely given the resilience in the global economy, value should be well positioned to resume its outperformance.
While history is not necessarily a reliable predictor of the future, it demonstrates that after the last interest rate increase, value tends to perform much better than growth. As the economy receives a boost from monetary easing, growth becomes plentiful rather than scarce and investors become less willing to pay a premium for it. High dividend and value have been the best performing equity categories over the 12 months after the last interest rate increase, while growth is the worst.
Valuation spreads have reached extreme levels
The performance deviation between growth and value stocks over the last few years has driven the valuation spread between the two to extreme levels, even wider than the peak of the technology-media-telecoms (TMT) bubble, during which the euphoria over telecommunications companies caused valuations for these stocks to balloon.
The current valuation spreads are stretched on both an intra-region and intra-sector view. Take the autos sector as an example, where you have Tesla trading on 70x historic price-earnings ratio (P/E) with a market cap over 10x larger than General Motors on 5x P/E.
Concentration risk in growth is concerning
Value investing remains a lonely place. Around the world, the proportion of equity assets invested with value managers has fallen to 5%-10%. Returning to the level of 2006-2007 would require a roughly three-fold increase in the current proportion of equity assets held in value funds.
Today’s extreme concentration in the US market also stands out. Such high expectations have already been baked into these few high growth companies, that even if they were to deliver on their astonishing guidance, returns may not follow. A good historical example of this is the “Nifty 50”, which were a group of 50 high quality US companies that were never supposed to disappoint on earnings because they traded at high valuations versus the market. But, once inflation and higher rates became more structural, and valuations compressed, the “Nifty 50” underperformed for a decade.
As it turned out, the market was right. They didn’t disappoint on earnings, outgrowing the S&P by 70% in the next seven years, but owing to high valuations, they still underperformed by c.40%!
Valuation, no matter how magnificent the company, is key. We feel that the combination of the current extreme valuation spreads, low positioning and favourable macro backdrop indicates that the potential for value to outperform could be significant.
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