The great rotation

27 May 2021

A great rotation from growth to value stocks is on the cards. Andrew Holt sifts through the evidence to find out what it means for investors.

The great rotation from growth to value stocks, which has been discussed for some time, appears to have finally arrived – and it could be a big moment for institutional investors.

There are several reasons to support the great rotation thesis. Firstly, value stocks should, in theory, see their earning power bene t from an economic recovery – which is the conclusion of several analysts’ economic outlooks published this year.

There is also the potential for the mammoth fiscal stimulus and economic recovery to produce higher inflation and force interest rate rises. Higher interest rates have a negative effect on assets with longer duration cash flows, and since the valuations of growth stocks depend on cash flows expected further into the future, the faith is that higher interest rates will cause capital to move into cheaper shares with cash flows of shorter duration.

The outcome of the US election and the discovery of effective Covid-19 vaccines have also had a stirring impact, prompting a rotation out of technology and other stocks deemed to benefit from a ‘lockdown’ type of world and into areas expected to capitalise on a speedier return to normal life and better economic growth.

Economic stimulus in the form of commitments to renewable energy and infrastructure will mean certain construction and utilities companies do well. President Biden’s $2.2trn (£1.6trn) infrastructure and green package aimed at increasing carbon neutrality in the US by 50% within nine years while boosting the country’s infrastructure is a major boost in this regard.

Overcoming underperformance

The strong consensus view is that value stocks – those shares often identified as cheap by some measure, typically their price-to-earnings or price-to-book multiples – are set to overturn a long period of underperformance relative to their faster growing peers.

With this rotation comes a whole new debate around the future of value investing – which in historical terms has proved an effective approach – and could well form the investing model for years to come.

Yet placed in a more recent timeframe, value investors have experienced lowly returns since the financial crisis, with the trend of outperformance for growth stocks, e-commerce and other technology companies further accelerating up to 2020. Put simply, during the past decade, the Russell 1000 Growth index has returned 17% annually, while the Russell 1000 Value index grew by 10% – a stark difference.

All this though is down to context. In the wake of the calamitous events of 2008/09, the low interest-rate environment created by central banks encouraged tech companies to use debt to drive growth. This model of massive investment to grow scale and eventually deliver returns attracted investors to go for ‘growth’ despite companies potentially running losses for years. Nevertheless, Amazon and Facebook are tech giants that have proved it is possible to deliver profits.

Another example is the S&P500 Growth index – heavily weight- ed to the technology sector – which delivered an annualised return of 15.8% in the past decade and by contrast, the value index – geared toward financials, healthcare and industrials stocks – lagged at 10.9%.

Two points can be made here. First, the large tech names that have boosted the growth indexes by delivering amazing numbers in recent years, raises a big question over whether such returns can be replicated in the coming years.

Secondly, with financials being a large part of the value indexes, and technology stocks making up the largest part of the growth indexes, much of the underperformance of value stocks since 2007 can be attributed to the devastating impact of the great financial crisis and the low interest rate environment that continued in its aftermath.

“With the benefit of hindsight, it’s no surprise that financials have struggled to keep pace with the biggest tech stocks since 2007,” says Michael Bell, a global market strategist.

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Warren Buffett, Berkshire Hathaway

Stretched valuations

Therefore, putting the argument back in favour of value, price discrepancies between growth and value have reached extreme levels. “One consequence of a decade of growth outperformance is that valuations are now stretched to levels that would have historically foreshadowed negative returns relative to value,” a researcher at one asset manager noted.

For example, US growth stocks trade at 52 times their cyclically adjusted historical earnings compared to 21 times for value stocks. That makes them the most expensive they have been, in relative terms, since the dotcom bubble around 20 years ago.

Yet in 2011, and again five years later, growth stocks traded at a lower premium to value stocks, but valuations are less supportive today meaning that a sustained value rally is much more likely than ever before.

What many market observers expect to happen is something akin to the crash of the popular so called “nifty fifty” stocks in the 1970s or the bursting of the dot-com bubble in 2000.

The tech bubble that popped at the turn of the century was, it should be noted, followed by a rotation into value stocks. That lasted from 2004 until 2008, at which time banks and other lenders were destroyed by the financial crisis.

The issue is that irrational exuberance by investors led to growth stocks being considered by many to be overpriced. It did not stay this way. Prices reverted to the historical mean of their performance, so investors should expect a correction.

Investor appetite

And this appears to be happening. Investors look to be turning away from the technology stocks that fueled a decade long equity boom, as the aforementioned trends encourage a shift from growth into value stocks.

The S&P500 Value index – made up of the top 100 S&P500 stocks deemed to be cheapest on price-to-book, price-to-earnings and sales-to-price ratios – has returned 8.6% in 2021, more than four times greater than the 2% gain recorded by the broader S&P500 index.

By contrast, the S&P500 Growth index, dominated by tech behemoths Apple, Microsoft, Amazon, Facebook and Alphabet declined by 3.8% during the same period. The turnaround in investor appetite looks unambiguous.

To further illustrate the point, BlackRock’s $14bn (£10bn) iShares MSCI USA Value Factor ETF has soared almost 40% since November 2020, easily beating the 23% gain for its ‘momentum’ counterpart. “Investors now seem a little wary of jam tomorrow growth stocks and seem to be preferring jam today companies,” is how Russ Mould, investment director at AJ Bell, puts the rotation from growth to value.

Offering another interpretation, global market strategist Michael Bell says: “The underperformance of value relative to growth since 2007 is now approaching levels only seen during the 1930s and the dotcom bubble. After such significant periods of value underperformance, the snap back in favour of value has historically been large and quick.” Investors be warned.

Investors now seem a little wary of jam tomorrow growth stocks and seem to be preferring jam today companies.

Russ Mould, AJ Bell

Superior longer-term returns

A key point for institutional investors, and pension funds in particular, is that value stocks should see superior returns over the longer term. Making them the natural bedfellow of pension schemes.

To support this, data compiled by economic sciences Nobel laureate Eugene Fama and Ivy league Dartmouth College professor of finance Kenneth French revealed that from 1927 through to 2019, value stocks outperformed growth stocks 93% of the time during rolling 15-year periods. The value premium – the excess return over growth stocks – was 3% per annum. This seems to settle any debate between value and growth.

The founder of value investing Benjamin Graham was looking for stocks of companies that were trading below a conservative estimate of their liquidation value – that is, less than their book value.

Warren Bu et then took the idea of value investing further by looking for stocks that traded below their ‘intrinsic value’ – including high-quality companies that could reinvest large amounts of capital at high returns. Buffet’s famous adage on his approach remains: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

You can’t touch this

But there is a modern twist to these impressive numbers. Physical assets, such as factories, were the foundation of business value and recorded as assets on the balance sheet when Benjamin Graham founded value investing in the 1930s. Now, according to Michael Mauboussin, a professor of nance at Columbia Business School, earnings and book value no longer means what they used to.

Professor Mauboussin’s assertion has real implications for the value versus growth argument. It means that if the worldwide economy continues on its trajectory of being more knowledge-based and increasingly reliant on new technologies – as it is clearly developing on these lines – then growth will outperform, because of the weighting in the dominant industries.

Pointing to this trend, last year growth stocks outdid value by more than 30%, with the technology sector accounting for almost 40% of the S&P500 – so it is the actual dominance of growth here that appears to a major factor.

In addition, the information age has ushered in the age of the stock picker, and the differentiation between growth and value is truly blurring – growth, but at a fair value price. The very suggestion would have Warren Buffett shaking his head.

Zero-sum game

Yet the current investment environment is shaping up to indicate a rotation into value, meaning institutional investors big on growth need to potentially readjust.

“Investors with a big bias towards growth stocks over value stocks are vulnerable to recession, reflation and regulation,” warns Michael Bell. “Therefore, it may be time to consider rebalancing portfolios to a more neutral balance between growth and value stocks after such a long period of growth out- performance,” he adds.

Although does it have to be an “either value or growth” situation for investor? Rob Morgan, investment analyst at Charles Stanley Direct, thinks not. “The question shouldn’t be whether value or growth is best, but how to find the best opportunities in each camp to populate a portfolio for the best returns.” Although Graham notes a rotation to value will not, or should not, necessarily mean a readjustment for growth.

“The likelihood that the performance of value stocks in 2021 will revert closer to their historical mean – which is a good thing – should not begrudge the possibility that growth stocks will continue their trend up – which is also a good thing: it’s not a zero-sum game.”

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