In the world of investing shares, investors are divided into two opposing camps that take a very different approach to investing. Growth investors invest in stocks that grow profits faster than average, and are expected to continue to do so. Investors are happy to pay a premium for this and examples would be Google or Facebook. In contrast value investing is the art of buying stocks which trade at a significant discount to their true value. These are stocks that are overlooked by the market without good reason.
The battle for supremacy between growth and value stocks rages on. Following value’s so-called “lost decade”, there was a marked rotation towards the style in 2016. This wasn’t to last and value has given up much of its gains versus growth over the first six months of 2017. We’re not prone to giving out market timing messages, however, it is worth putting the relative performance of these distinct investment styles in longer-term context. But first …
What’s happened in 2017?
Growth’s continued march north has come about courtesy of the US IT sector (driven by the so-called FANGs: Facebook, Amazon, Netflix, and Google), and consumer staples in the UK and continental Europe (driven by the so-called “bond proxies”). The valuation gap between these racy US tech companies and sleep-easy bond proxies, and everything else has become wider. We are increasingly fearful of the former as in equity investment, valuations will always triumph over quality in the long run because as their valuations rise, stable businesses can become very dangerous investments.
Mr Market is ignoring the fundamentals
There is, however, some comfort to be found in value’s underperformance this year. Across the globe, the majority of the performance gap between valueand growth can be accounted for by the higher price/earnings (P/E) multiples of growth stocks. In other words, investors have been willing to pay even more for those “growth” companies than in the past. An environment where P/E multiples are rapidly outstripping even the most bullish of sell-side analyst forecasts has echoes of the long build-up to the dotcom bubble in 2000. It is evidence of a classic behavioural bias where investors extrapolate current trends when forming future expectations.
The chart below chart shows earnings-per-share growth and price performance of MSCI World Growth and MSCI World Value of the first half of 2017. While the price of growth stocks has outstripped higher EPS growth, the market has ignored EPS growth of value stocks.
The valuations of growth stocks are now pricing in ever-higher future earnings despite global profit margins nudging to all-time highs. History suggests that this cannot last forever, and in the past a market dislocation such as we are seeing now has been a precursor to value’s outperformance as expensive growth companies withdraw to lower valuations. The chart below highlights the extent of growth stock’s absolute valuation on price-to-book, which is now far higher than at the peak of the dotcom bubble in 2000.
Source: Schroders, Bloomberg, October 2017
This should in no way be read as any sort of invitation for investors to try and time when they put money in the market.
Value investment is a long-term endeavour and its performance could easily continue to suffer in the short term. That said, we would also point out the investment style has displayed a consistent pattern of mean reversion over more than 100 years.
Nevertheless, given the scale of the style’s underperformance, we strongly believe its potential recovery could be the most attractive investment opportunity today’s markets now offer patient investors.
Moreover, when higher asset prices are fuelled by debt, losses tend to be magnified. History suggests that many investors will come to regret the high price they are paying for tech giants or bond proxies (stocks which have the yield characteristics of bonds) today.
Author: Andrew Williams, Associate Product Manager, Equity Value and Grace Canavan, Head of Intermediary Business Development, Ireland. Website www.Schroders.com and contact number +353 (0) 85 254 9839.
Important information: The views and opinions contained herein are those of Andrew Williams and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, nor to provide advice of any kind. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. Issued by Schroder Unit Trusts Limited, 31 Gresham Street, London, EC2V 7QA. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority. UK12325