investment viewpoints

    Quality is the decider in the battle between value and growth

    Quality is the decider in the battle between value and growth
    Pascal Menges - Head of Equity Investment Process and Research, Client Portfolio Manager

    Pascal Menges

    Head of Equity Investment Process and Research, Client Portfolio Manager
    Didier Rabattu - Head of Equities

    Didier Rabattu

    Head of Equities

     

    Need to know

    • The Value versus Growth debate is raging among investors, with relative performance between the styles exhibiting spikes that have not been seen in 20 years. 
    • In our view, investors should not be overly concerned with choosing one style or the other: it is more important to focus on quality and capture alpha in Growth or Value stocks.
    • During 2020-2021, many ’boring’ quality companies were left behind that now look increasingly attractive. As we enter a tightening cycle, and as EPS growth normalises, these ’boring companies’ will likely stage a comeback for investors looking to build increasingly resilient portfolios. 
    • Focusing on the ability of companies to create economic value across cycles, their cyclical and secular growth characteristics, and building portfolios that blend styles is what we favour across our high-conviction strategies.

     

    Value versus Growth 

    The nature of growth and value stocks is changing rapidly. As we enter a new market phase, quality will be the most important driver, in our view.

    The past few decades have been characterised by somewhat muted weekly performance spreads between value stocks, loosely defined as cheaper companies, and growth stocks, those recognised as strong earners. These spreads rarely fell outside of a tight range of +/-0.8%.
     

    Key dates: Value’s weekly performance spikes against growth:

    -    April 2020: The pandemic hits and leads to a physical halt of economic activity due to containment measures. Governments and central banks rush to announce unprecedented monetary and fiscal support
    -    May-June 2020: Infection rates slow, and the world begins the process of unlocking their economies, unleashing a wave of optimism
    -    November 2020: Joe Biden wins the 2020 US Presidential election, and Pfizer announces high efficacy rates for its vaccine, followed by Moderna
    -    March 2021: The US Senate passes the USD 1.9 trillion American Rescue Plan Act, while the Federal Reserve officially adopts flexible average inflation targeting
    -    January 2022: A hawkish Federal Reserve and job reports drive a rise in real interest rates

     

    However, over the course of the last few months, equity markets have been shaken by pronounced movements which have not been seen in 20 years. Spikes of more than two standard deviations were previously considered exceptional and largely confined to periods such as the global financial crisis. Since the onset of the pandemic, world equity markets have swung from a period of severe drawdowns – approximately 30% on a weekly basis – to the fastest recovery on record. Consequently, weekly swings between growth and value have hit four standard deviations on six occasions since early 2020.  This year has started along the same lines.

     

    Figure 1: MSCI World Value vs MSCI World Growth: weekly performance spread

    Source: Bloomberg, LOIM calculation

     

    These episodes of outperformance of value stocks over growth stocks highlight that equity markets are exhibiting extreme stylistic positioning. Value companies have lagged the market since 2015, which marked a more decisive foray into negative interest rates, and the situation was only exacerbated by the pandemic (figure 2).

     

    Figure 2: Value versus growth over the long term

    Source: Bloomberg, LOIM calculation

     

    A new phase for markets

    We are now entering a new phase for global equity markets, shaped by new macro conditions: structurally higher inflation, rising interest rates, progressively tighter financing conditions and normalising growth dynamics after an extended period of massive financial and fiscal support. Investors’ preferences are shifting as we witness a rotation into value.

    For instance, growing companies are now more evenly distributed across a greater range of sectors, which is putting pressure on valuations. This pressure is being accentuated by two dynamics. First, rising interest rates are putting pressure on the valuations of long-dated assets like high-growth, loss-making companies for which terminal value is a heavy component of their overall valuation. Second, two industries – European banks and oil & gas producers - have historically been severely impacted by idiosyncratic events, such as falling rates and commodity prices, and increased regulation, which has disproportionally pushed them into the value category. The change in macro conditions is fueling a long-overdue rally for these industries.

    However, investors need to be aware that the barrier between value and growth stocks is porous. Over the last 12 months, we have seen an increased proportion of hard cyclicals, such as industrials and energy, as well as financials, entering the growth camp to the detriment of IT and healthcare stocks.

     

    Figure 3: The top 20% of growth companies split by sector

    Source: Bloomberg, LOIM calculation

     

    Quality will be the most important driver

    In market conditions such as these, investors face the risk of being wrong-footed. We believe they should not simplistically focus one extreme (value) at the expense of the other extreme (growth). As illustrated in figure 3, the nature of growth and value stocks is changing rapidly. In our view, as we enter a new market phase, quality will be the most important driver. We would define quality companies as those with strong financial characteristics across market cycles – capital efficiency, strong cash flow, low level of dependency on capital markets – using our Excess Economic Return methodology.

    To illustrate this point, we have split value companies into two categories. There are those companies that have historically been high quality but that have entered the value category because of specific downturns in products or sectors, and there are those that have never demonstrated an ability to create economic value. We have dubbed these ‘smart value’ and ‘dull value’ stocks. Similarly, we have split growth stocks between those that are heavily reliant on capital markets to fund their growth, and those that can self-finance their expansion. These are ‘unfunded growth’ stocks and ‘funded growth’ stocks, respectively. This exercise clearly illustrates that quality remains a source of alpha differentiation (see figures 4 and 5).

    In our view, it is important to be a true quality-focused investor who can capture the alpha in growth and value stocks. This source of alpha can be unearthed, in our view, by focusing on the financial strength of companies, as well as their cyclical and secular growth perspectives, before building a portfolio with a more blended approach. 

     

    Figure 4

    Figure 5

     


    Sources: LOIM calculation

     

    Beyond focusing on the intrinsic financial quality of companies that compose Value or Growth, we continue to search for companies can generate excess economic returns over the long term and that are cheaply priced. These are dubbed DEER (Discounted Excess Economic Returns) companies and tend to be long-term winners (figure 6). However, these companies had a relatively muted performance up until end 2021 and have been left behind (figure 7) as they neither fall in the camp of Value or Growth, per se. In fact, they are perceived as ’boring’. As we enter a tightening cycle, with mounting concerns over growth, and as EPS growth normalises, many of these ‘quality laggards’ will likely become more sought after.

     

    Figure 6

    Figure 7

    Sources: LOIM calculation

     

     

    Finding alpha

    Smart value and funded growth stocks have generated superior performance throughout the pandemic. This is an expression of how prioritizing growth over value, or vice versa, is of less importance to investors in the current climate. Given the rapidly changing nature of growth and value stocks, now is the time for investors to focus on quality within styles in order to find sources of alpha. In addition, many good secular companies that have previously been deemed boring because they didn’t fit in either the Growth or Value camp, have lagged somewhat and could prove to be a fertile ground for opportunities.

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