Making the sense of the rotation from growth to value

Sam Slator 16/02/2022 in Equities

The intense style rotation from ‘Growth’ to ‘Value’ that we witnessed in January 2022 was ferocious, and the speed with which it occurred was unprecedented.

As our own Juliet Schooling Latter pointed out in a recent podcast, Goldman Sachs reported that value outperformed growth by 24% in just five days.

“Moreover, this occurred against a backdrop of eroding risk appetite marked by falling equity markets and a sell-off in small and mid-cap equities in favour of large caps, said Cedric Durant des Aulnois from Montanaro.

What’s behind this brutal change of market sentiment?

Two things really. The pandemic and inflation. Pandemic winners are becoming losers and vice versa as economies are set to fully reopen, while higher inflation and the expectation of higher interest rates have now triggered a reversal in growth stocks.

As it happens, pandemic winners also tended to be growth stocks, so their outperformance and the subsequent reversal has been more extreme than it may otherwise have been.

“The scarcity of growth over the last decade or so drove the pivot to ‘long-duration’, resilient, high-quality growth investing strategies,” explained James Thomson, manager of Rathbone Global Opportunities fund. “But COVID-19 has changed the calculus… growth is no longer scarce, and the one-sided dominance of growth strategies is starting to wane.”

“As money gushed out of the FAANGs and other technology and healthcare names, the banking, materials and energy sectors enjoyed a strong revival,” added Cedric.

“Many parts of the market have been starved, so a period of catch-up has been likely for some time,” continued James. “I think it means that we’re getting back to an investing world that isn’t so binary anymore.

“The open-ended nature of rising interest rate expectations has been the trigger for this mammoth shift and volatility will remain high until the market can properly frame the increases in inflation and rates.”

It’s also worth remembering that even before the pandemic, the growth/value divide was at a record level. When Covid came, this widened the divide further. Now the pandemic is coming to an end, some of this is unwinding because the withdrawal of emergency stimulus measures supports the case for value stocks.

Will value continue to outperform growth?

“Everything will depend on inflation,” said James Yardley, senior research analyst at FundCalibre. “If inflation stays high or rises further, then yes. If inflation peaks and falls back to 3 or 4%, then no.”

Rajiv Jain, Chairman and CIO of GQG Partners and manager the firm’s Emerging Markets Equity fund, said in his annual letter in December that if the world does look somewhat like it did from the late 60’s (nifty fifty) into the 70’s (inflation staying higher for longer) “many growth investors are likely to suffer sub-par returns, given a general lack of exposure to some of the best performing sectors during that period (think energy, financials and utilities).”

At the time, Rajiv was becoming more cautious and valuation sensitive, looking for businesses with a higher degree of earnings certainty or those where he believed their outlook was much better than consensus.

“We believe that the CPI could still be much higher than expected for the remainder of 2022,” he said. “If inflation is much less temporary than market participants think, and the dreaded “wronger for longer” takes hold, we believe equities with the longest duration (think work-from-home and high-revenue growth companies) could see the most downside risk.”

If inflation does stay high, the UK stock market could be a beneficiary.

“The FTSE 100 in particular has been shunned over the last ten years for three key reasons,” said Hugh Sergeant, manager of ES R&M UK Recovery. “It’s been seen as too value-oriented in a world that favoured growth stocks; too skewed towards important but slower-growing industries such as banking, energy and healthcare; and too risky due to Brexit. But all the negatives are now becoming positives.

“Value is at a multi-generational low point and there are huge opportunities to be taken in this area as investors re-discover the benefits of paying a sensible price for a stream of profits and cash flow. Added to this, many recovery stocks are yet to see share price recovery, small caps have lagged badly recently, and many beneficiaries of the reopening of the economy are back to relative lows.”

But if inflation does fall back or central bank policy errors result in slowing growth, it could be a different scenario.

“Overall, I still believe deflationary forces will reassert themselves,” said James Yardley. “There is simply too much debt in the system for the world economy to support many interest rate rises.

“The other thing to remember is that tech businesses have not just done well because of low interest rates: technology has become critical in all our lives and that is not going to change.“

James Thomson agrees. “While the rotation in valuations is understandable — and probably overdue — the change in company fundamentals may not follow,” he said. “The digital transformation is not going away. JPMorgan alone is spending $12 billion a year on tech. Businesses can’t just turn off enterprise software because the economy dips, it’s mission critical and irreplaceable.

However, Chris St John, manager of AXA Framlington UK Mid Cap fund, says that the ‘growth’ versus ‘value’ debate remains unhelpful when investing as “each term comes with presumption and caricature in terms of what type of company or stock fits each grouping. Even within each group there is inevitably a huge variety of businesses and value can be found in the growth bucket as well as growth in the value bucket,” he said.

And this is something his colleague Stephen Kelly, who manages AXA Framlington American Growth, has been taking advantage of. “Valuations have now meaningfully compressed for many growth stocks, but growth rates have not,” he said.

Simon Brazier, manager of Ninety One UK Alpha is also of this opinion and is “doubling down” on opportunities in quality companies that have more attractive valuations today.

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