Growth vs Value

The debate over the merits of growth vs value investing was somewhat moot over the past decade, as growth tended to outperform value. But the dynamic has shifted recently and value is now in vogue. But what has led to this change and where does the argument go from here?

After reading this article, you will have an improved perception of the growth vs value debate, and the market conditions that steer each style. You will have learned how these style biases may operate aside one another and the optimum market conditions for each. In addition, you will understand how ESG investing interacts with each end of the spectrum.

30 minutes of CPD include:

• Article: 20 mins
• Related learning video: 14 mins
• Related learning articles 5 mins
• Quiz: 5 mins

It’s an age-old debate: value or growth? One (growth) seeks to invest in companies that are growing quickly and therefore display strong earnings growth, while the other (value) seeks companies that appear to be undervalued in the marketplace. The answer to which one is best is not necessarily clear cut, as multiple factors can mean that one will deliver better performance than the other at different points during the economic and market cycle.

Throughout much of the past decade, the debate between the merits of investing in growth companies and value companies has been something of a moot point, with those in the growth category having significantly outperformed as equity markets ran hard.

Value investing had its moments of outperformance at certain points during that period, but the prolonged environment of loose monetary policy and low interest rates was more supportive to growth stocks, with technology companies in particular being the main beneficiaries.

Companies’ fortunes finally began to dip in 2021, as the global economy re-opened in the wake of the pandemic. At this point, it became clear that inflation was in the system, owing to the pandemic’s disruption of the global supply chain, and this, along with the prospect of rising interest rates, had a near immediate impact on growth stocks.

Since then, inflation has skyrocketed globally, as lockdowns in Asia have continued to impinge on the supply chain, while Russia’s invasion of Ukraine placed a premium on commodities. Central banks began to raise interest rates in an attempt to curtail inflation. During this time, value stocks have continued to outperform, while growth stocks have suffered historic losses.

In many ways, this dynamic had long been a case of when, rather than if, as many had forecast the impact of inflation as a turning point in the debate.

“We talk to a lot of fund managers, and would always ask them, ‘What’s going to make value outperform?’ and the recurring answer was inflation,” says Darius McDermott, managing director of FundCalibre. “This was the main thing that was presented as being a catalyst for value to outperform – and boy, have we got inflation.”

At the midway point of 2022, the impact of inflation on stock and bond markets cannot be understated. Central banks across the world, but most notably the US Federal Reserve (seen by many as a harbinger for global economic policy), have raised interest rates in an attempt to suppress the surge in prices.

So, with the pendulum having finally swung, we felt it worth revisiting the growth vs value conversation, to better understand the current environment and whether the debate remains fit for purpose.

Explaining the current value/growth dynamic

The paradigm shift within the growth/value debate has been stark, with fortunes having been reversed seemingly overnight. But is this purely down to inflation, or is there a more nuanced explanation to be found?

Peter Michaelis, Simon Clements and Chris Foster, fund managers of the Liontrust Sustainable Future Global Growth fund, had the following considerations.

“The major trigger for this change has been a backdrop of higher inflation and rising interest rates,” they say. “For companies where the market expects strong growth for years to come, a large proportion of the valuation is attributed to cash flows in the future (so these are known as long duration); conversely, for stocks with lower expectations, little value is ascribed to future growth and the bulk of the value is in near-term cash flows.

“This means companies with strong growth expectations have a higher sensitivity to interest rate changes relative to those with lower growth prospects, and this shift in the macro situation has therefore hit growth stocks harder”.

Mark Hawtin, manager of the GAM Star Disruptive Growth fund, echoed this sentiment. “Duration assets have been sharply repriced. Given that higher growth normally associates with lower profitability, the future profits are being discounted more aggressively hence the price declines,” he says.

On the value side, Ben Whitmore, manager of the Jupiter UK Special Situations fund, was quick to highlight value’s long-term track record, but acknowledged the more recent struggled of the style bias:

“The past five years have been one of the worst periods of underperformance on record for our style,” he says. “It has been dominated by the performance of growth companies, and valuations became stretched. Over this period, despite the headwinds to our style, we continued to focus on identifying lowly valued companies with strong balance sheets and good franchises.”
Ben also acknowledges the conflict between Russia and Ukraine as a key driver of inflation and an unfortunate catalyst for value. Nevertheless, with interest rates rising, stocks within sectors such as energy and financials have been the big winners across global indices.

Related learning: Investing in complex market conditions

How long will this status quo last?

Historically, value tends to outperform during a cyclical rally and underperform during an economic turndown. This can change over time, as different sectors move in and out of value, however. For example, tobacco is an exception as it is a value sector which tends to outperform in a cyclical downturn.

With that in mind, how long can we expect value stocks to remain in vogue this time around?

“When something dominates for such a long period of time, you often get a snap back,” Darius McDermott says. “Now, is that snap back going to last 10 years like the previous trend did, or is it going to last ten months or ten weeks?”

For Mark Hawtin, the requirement for a growth renaissance is clear.

“Stability,” he says. “A clear consensus on the path for interest rates will be enough even if they continue to rise. I expect by the end of the year, the picture will become clearer but that markets will start to discount that with a bottom in growth names. As an example, Chinese growth names that started to fall in March last year have already bottomed relative and are outperforming. The same will likely soon be true for the growth end of equities.”

Related learning: How long will the value rally last?

Although much of the inflationary forces currently emerged during the pandemic, the market movements of 2022 so far, particularly in the situation in Ukraine, have put extra wind behind inflation. But given the way value has responded to such conditions, how should we expect it to fare once inflation peaks?

“We believe that undervalued companies outperform over time rather than any particular factor or company characteristic,” says William Lam, manager of the Invesco Asian fund. “The current trajectory of higher inflation and higher interest rates reduces the value of earnings generated far into the future, and the valuation of companies with distant projections. Value can continue to outperform if these concerns remain, but it is more important, we think, to invest in companies where growth expectations are underappreciated regardless of such factors and would expect outperformance to come from stock specific decisions. “

Can value funds cater for ESG?

A more recent wrinkle to the debate centres around ESG and its increasing prominence within the asset management space.

With growing regulatory pressure for managers to invest sustainably, one could argue that investors wishing to align their investments with ESG principles are being unwittingly herded towards growth, as the sector skews more towards technology stocks.

The question is whether value investing can cater for an ESG mandate.

“The simple answer is yes,” William Lam says. “As active, fundamental managers, we have an advantage when it comes to integrating ESG into investment decisions. Day to day we continuously engage with companies and thus not only can we assess the impact of ESG on a company’s fair value, but also have the ability to engage and promote best practices in order to help enhance the value of our clients’ investments.”

He adds: “Growth (or internet) companies may have been perceived as ESG leaders given the focus on E and their lack of tangible assets, but they are prone to S issues which should not be ignored (perhaps overlooked by green funds focussed on E). We believe that ESG should be considered holistically in order to make better investment decisions.”

Meanwhile, Ben Whitmore says, “stewardship is embedded into our investment process, and we believe engagement is crucial.”

“To us, the direction of travel is important, and we believe you have to be part of the conversation in order to effect real positive change.”

Key aspects for financial advisers to consider

When quizzed on whether the styles can co-exist within a portfolio, the team behind the Liontrust Sustainable Future Global Growth fund felt that the argument needed reframing. “We would question how useful value and growth are as terms for investors, especially given the prevailing idea of two warring tribes forever pitted against each other,” they say.

“All investors, whether considered value or growth, are trying to identify securities where the current price does not reflect intrinsic value. The only real difference between investors is time horizon: some (including us) focus on the long-term growth potential of cash flows whereas others prefer to concentrate on near-term cash flows that are underappreciated.

“This is the critical point that is currently moving markets so violently – what rate do we use to discount those future cash flows? We would suggest looking very carefully at what individual funds are trying to achieve rather than automatically buying into the growth versus value narrative.”

A reminder of the learning objectives:

• Understand the rationale behind the current trajectory of growth and value
• Learn the optimum conditions for both styles and how they can co-exist
• Awareness around ESG’s role in the growth vs value debate