All that glitters is not gold.
This aphorism captures the essence of the value investment philosophy. Stemming from the wisdom of Professors Benjamin Graham and David Dodd, the value philosophy looks to focus on stocks trading below their fundamental valuation level and carrying both low multiples and high returns. By extension, we refer to stocks presenting these features as value stocks.
At the other end of the scale lie so called growth stocks, whose economic performance correlates only weakly with GDP growth. Long-term business revenue predictability grants these companies valuation multiples that outpace the market average. Technology stocks, non-cyclical consumer goods and some service providers typically fall within this category.
As the graph below shows, the relative valuation for value stocks, compared with growth stocks, as measured by various traditional financial indicators, has hit a 17-year low.
In the past, investment strategies favouring value stocks have tended to outperform growth stock strategies. Since 2008, this situation has changed due to a new market configuration. While global growth has been buoyant and even booming, interest rates have fallen for reasons that have nothing to do with the economic backdrop. The 2011 eurozone crisis and subsequent political backwash, Brexit, US-China trade tensions and lower oil and commodities prices all unnerved the market and prompted the introduction of accommodative central bank policies that have been pursued despite the absence of any additional economic deterioration.
The situation is unprecedented: previously, growth periods went hand-in-hand with higher rates while slowdowns, although much less frequent, were accompanied by falling rates. Accordingly, growth stocks tended only to outperform during economic slowdowns. Yet in the past decade, growth stocks have benefitted almost exponentially from a collapse in the risk-free rate and a buoyant economic backdrop. Combine the resulting higher earnings with favourable multiples and add a dash of technological disruption and you have a recipe for generating the gap between relative valuations and performance that is evident in Graphs 1 and 2.
And that’s not all. Investor perceptions have changed. The enormous appetite of Asia and especially China for luxury goods has apparently, given Asia’s extraordinary momentum, made a sector previously considered as cyclical distinctly less dependent on economic shifts. And valuations now reflect this. Meanwhile, tighter regulatory frameworks in the banking sector, for the sake of financial stability, and industry and car manufacturing, for the sake of the environment, are a drag on what were traditionally perceived as value stocks.
As the graph above indicates, aside from the telecoms bubble at the end of the 1990s and a few other exceptions, value strategies outperformed growth strategies from 1975, when the indices were created, until 2007. Since then, the situation has reversed, and value stocks are now at their relative lowest since 2001.
However, the trend seems to have hit a turning point three months ago. As things stand, the worst Brexit scenarios have dissipated, China and the US seem to be getting along, and unemployment is falling across the OECD. Is this bad news for growth stocks? No. Anything but. And yet, since 1 September 2019, the agri-food sector, for instance, has fallen 9%, massively underperforming the market rise of 7%. In addition, interest rates have tightened – albeit slightly – over the period from 0.3% to 0.4% depending on where you look (*Source : SX3T Index, Eurostoxx Food & Beverage. From 31st of August to year end, 2019). Could this be the canary in the mine shaft? It’s not impossible. Indeed, while the paths of growth stocks seem increasingly fraught with challenges and pitfalls, quality can now be found in certain cyclical stocks.
The mistake that investors have doubtless been making in recent years is that growth can be confused with momentum. Momentum is not about how healthy a company is, nor its capacity to grow and thrive over the long term. Momentum is a short-term consideration. Momentum investors do not really want to know if a company doing well. They want to know if it is doing ‘better’ or ‘worse’.
All that glitters is not gold. And momentum is not growth. As bond yields move back to positive territory, the market may be about to see the difference.
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The opinion expressed and the charts are dated from the day it has been published, and liable to change.
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