How should investors position their portfolios after more than a decade of disappointing value returns? Is it time for a style rotation, or can investors look within value and growth stocks for reliable capital appreciation and income?

Stock selection has always been about comparing the current price of a security to its fundamentals and assessing whether that price is “fair” relative to future expectations. Although both value and growth investors look for underpriced stocks, there are key differences:

• Traditional value investing focuses more on stocks which are “cheap” relative to fundamentals like future earnings (consensus) estimates.
• Traditional growth investing focuses more on stocks that could produce higher-than-consensus earnings growth.

In other words, the two styles share an interest in evaluating the present value of a company’s future earnings, but they differ in their emphasis on the role of earnings estimates. This foundation has led value and growth to develop into distinct approaches, which is reflected in market indices and some managers’ investment orientations.

The cyclicality of value-growth returns over different periods in history, has prompted continued investor interest in capturing style rotations. But the latest cycle throws caution on the persistence of this long-term relationship. Do investors need to re-assess how they benefit from value and growth investing going forward?

Value’s long-term, historical success

Value stocks held a significant advantage over growth stocks up until the end of 2007. A US$100 investment on 31 December 1974 in MSCI World Value Index would be worth US$6,123 on 31 December 2007 – an outperformance of 130% over an equivalent growth investment. However, the last thirteen years have reduced the gulf between value and growth stock returns, with the value premium dropping to 21% by the end of 2020.

Figure 1: Long-term returns of MSCI World Value Index and MSCI World Growth Index

Extended periods where value has been out of favour relative to growth are not new. As well as the years following the Global Financial Crisis (GFC), this also took place after the Great Depression in the 1930s (based on Fama and French’s US data).

Figure 2: US value drawdown relative to growth for Fama and French and MSCI

Value and growth exhibited a cyclical pattern between World War II and the GFC, when value recoveries consistently took place during economic recoveries, in the aftermath of stock bubbles (when asset prices rise far above fundamentals) and where a recession followed a bear market¹.

For example, in the 1970s, it was high-quality growth companies such as Pepsi, Gillette, Disney, Wal-Mart and Polaroid that drove the “Nifty-Fifty” bubble and powered returns. When the bubble burst, value outperformed growth, not only in the bear market but across the full downturn–recovery cycle. The expansion of internet-related companies in the late 1990s/2000s, such as Ask Jeeves, Yahoo!, Pets.com and Napster, fuelled another bubble with the same pattern: value stocks experiencing negative earnings growth and growth stocks chalking up strong gains. Many of those technology companies subsequently went out of business and value stocks once again provided positive relative returns.

Style rotations have become more difficult to predict

Despite the long, slow economic expansion following the GFC, value uncharacteristically underperformed, as shown in Figure 3. Can investors still rely on value stocks rising in an economic recovery?

Figure 3: Value outperformance during economic recoveries

1. Source: Value in Recessions and Recoveries – Vitali Kalesnik and Ari Polychronopoulos, June 2020

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.