It’s the holiday season up in the Northern hemisphere. With it comes with the need to spend time with relatives as the world gets back into a post-pandemic groove. However, that’s not the type of relative we are talking about today.
Much has been said about the growth vs. value debate. While this is not the only sectoral dimension to consider when calibrating one’s portfolio, it certainly warrants some inspection. Geographic allocations and considerations are also key but will likely be a topic of a follow up post.
Lets dive in.
When is growth, actually value?
The prevailing narrative of categorizing stocks into ‘growth’ or ‘value’ ignores that some ‘growth’ stocks may actually still represent ‘value’. Let’s unpack this a little.
Firstly, a growth stock is generally any stock whose rate of ‘earnings growth’ is expected to exceed the average growth of the market. A ‘value’ stock is generally defined as a stock whose shares appear to trade at a price below its implied or intrinsic value as determined by its cash flows, earnings, and other fundamentals.
From this, it becomes clearer that a stock can be both a growth and value stock at the same time. However, generic market indices tend to ignore some of these nuances. As such, generalist categorizations see growth stocks exhibit higher multiples, lower dividends (if any) and traditionally lower cash flows.
It is precisely these features which help explain why growth stocks have been exceptionally sensitive to changes in inflation expectations and commensurately, the yield curve. The links provided include my previous posts and podcasts on these topics. Check them out for a quick primer on these related concepts.
The chart above shows the directional correlation between the US 10-year yield (inverted) and the relative performance of growth stocks vs. value stocks. As inflation expectations ease and yields drop, growth (or stocks with cash flows discounted from much further in the future) tend to outperform and vice versa.
The further into the future cash flows are expected, the higher the price impact from changes in the discount rate today. Think of growth stocks in a similar vein to extremely long duration bonds (for those with a fixed income flair).
Growth is back…or is it?
Last year, earnings expectations were slashed amid a pandemic. The bounce back of markets at record highs, but also in earnings expectations and subsequent higher EPS revisions by analysts has been astounding.
Over the short term (last quarter), bottoms up earnings revisions on the S&P 500 have all been supportive and in many instances playing catch up with a market running hot.
In fact, when viewed over the longer term, quarterly revisions to EPS estimates are now higher for a fourth consecutive quarter. We can park the debate on whether analysts EPS estimates should be used as a leading or lagging indicator.
The point to be made is that earnings have surprised expectations for close on a year now. This has vindicated the bulls and castigated the bears. We are also arguably only starting to see the uptick from stimulus measures come through which begs the question, ‘how much is priced in?’.
For those who follow my work more closely, you will know that I am a believer in market and economic cycles. I do not know when cycles will turn, and I do not know how far a particular cycle will go.
What I do know is that cycles help me understand the balance of probabilities of an outcome. By overlaying my views of short-, medium- and long-term cycles, I craft my strategic (long term) and tactical (shorter term) plans.
Let’s look at the rolling 12 month return on the MSCI All countries World Growth and Value indices. Firstly, by mapping 12 month rolling returns, I seek to observe both the cyclical nature of long-term market returns as well as the correlation between these 2 categorizations.
In fact, for the early part of the previous decade heading into the global financial crisis, value investing ‘owned’ the show. Thereafter, in the era of monetary (and now fiscal) largess, growth stocks came to the fore.
Tying into the first chart of this article, this makes sense as the ‘longer duration’ growth stocks outperformed in an era of lower rates. This is why the debate on where interest rates go becomes so critical. it may well be setting the path for the next long-term cycle and the corresponding asset allocation.
A new normal?
Let’s take the data from the above chart and represent the relative ratio of Growth to value stocks again, over the longer term. Let us also map this to what a ‘normal cycle’ looks like on this ratio.
From the chart below, we can see that near the end of 2019, the growth outperformance had already reached 2 standard deviations from the mean. The pandemic response and corresponding fiscal stimulus on top of other market dynamics, has led this ratio a 4-5 standard deviation outperformance before coming back to the mean. (We will not discuss an even longer-term view of the cyclicality of the mean here).
The resumption of short term ‘growth’ outperformance has stabilized the ratio around the mean and the question is now whether we see a slightly more extended ‘growth’ cycle or a deeper correction from here, favoring value stocks.
I’m somewhat old-school. I prefer to look at the world through a ‘value’ lens. That said, I am open to the fact that when a stock is growing faster than the market, but also exhibits the properties of a value stock that it may be a true gem. A focus on sustainable cash flows and a healthy balance sheet are key.
In this vein, I return to my opening comments. Despite these dynamics, the prevailing narrative of categorizing stocks into ‘growth’ or ‘value’ ignores the fact that some ‘growth’ stocks may still represent ‘value’.
Lastly, not overpaying for these features is critical as the return on an investment is often determined by the price you pay for it. On this point, an understanding of cycles and market behavior is a fundamental to realizing when the premium paid for an investment is at a cyclical high or low. And, that sometimes, it’s all relative.
These blog posts are commentary. There is ALOT more beneath the surface.
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*Sources – Moe-Knows.com, Tradingview, Factset