Do numbers suggest a greater value opportunity is yet to come?
investment trust Fidelity Special Values Asset typeInvestment trustsSectorUK All Companies
There has been much talk of value investing and growth investing over recent years. But what actually is meant by ‘value’ and ‘growth’?
Put simply, value stocks are stocks that are ‘cheap’. The most traditional way of calculating this is in terms of ‘book value’ or the net assets on a company’s balance sheet. If the company’s net assets are greater than the value of the company implied by its share price, it is considered to be a value stock.
Value investing is also associated with buying stocks that are currently out of favour and trading on low price to earnings (PE) multiples (the PE ratio is probably the most common way to value a company, measuring its current share price relative to its earnings per share). Think slow and steady – the tortoise versus the hare of growth.
By contrast, growth stocks are priced higher than the market, trading on high PEs. They have above average growth and are expected to earn a lot more in the future. So investors are willing to pay a premium for these stocks with the expectation of selling them at even higher prices as the companies continue to grow.
While the earnings of some companies may be depressed during periods of slower economic improvement, growth companies may potentially continue to achieve high earnings growth regardless of economic conditions. Think dynamic growing sectors, such as technology. Expensive stocks do come with a risk warning though – if their growth isn’t maintained then their high PE can come tumbling down.
Historically, over the very long term, investing in value stocks has delivered better returns than investing in growth stocks. The theory goes that investors tend to overpay for exciting new growth companies and often these firms fail to meet their high expectations. By contrast, investors underestimate the ability for cheap value stocks to recover. However, over the past few years, growth stocks have dramatically outperformed value stocks.
Growth stocks tend to thrive in a low interest rate world, and we have had low interest rates for many years now, subsequent to the financial crisis. Also, in a world of low economic growth or indeed recession, growth stocks are favoured by investors, as they can grow at a faster and higher rate than the things around them. If the economy is only growing 2% in a year but a company is growing by 5% or more, that’s going to be attractive.
Value investors were granted a reprieve when they finally saw value stocks start to outperform towards the end of last year on news of the discovery of successful vaccines against Covid. With the prospect of a bounceback in the economy and potential higher inflation, suddenly value seemed attractive once again. But the jury is out on whether this value rally is over or just at the beginning.
However, just because your style is out of favour, it doesn’t mean you can’t produce excellent returns for your investors, as Hugh Sergeant, manager of ES R&M UK Recovery explains in his recent podcast. He also tells us why multiple holdings are good for value strategies, but fewer holdings work better for growth strategies.
Nick Kirrage, Schroder Recovery
“Value has had quite a renaissance in the past 12 months. The style rotation began on ‘Vaccine Monday’, as news broke that a credible, distributable vaccine was discovered which could start the road to recovery. Value pockets of the market, such as financials and miners, were typically more economically sensitive through the pandemic and therefore benefited the most from the news. Since then, the rotation has run out of steam it would seem, and we’re back to defending the role of the value investor in a world of low rates, quantitative easing and various disruptive forces.
“If what you pay matters, and equities are expensive, how can we be so excited about prospective returns for investors from today? Because valuation dispersion within the market – the gap in fundamental valuation between the most highly rated shares and least highly rated – remains at extreme levels.
“On a global basis, the gap is more extreme than at the dotcom peak in 2000. Valuation dispersions mean that returns from the most undervalued parts of the market can be stellar over the coming years, even if overall market returns prove to be paltry. If the valuation gaps that we see today are to return to something more like normal in the context of long-term history, this value recovery has a long way to go.”
Ben Whitmore, Jupiter UK Special Situations
“While value investing does work over time, the path it takes is not linear. This has been evident over most of the past five years, where value as a style has struggled. Over this period, we have seen the most expensive parts of the market become even more expensive, while the cheapest parts of the market have struggled to keep pace.
“The difference in valuation between the cheapest and most expensive parts of the market is what’s known as valuation dispersion. It can be thought of as a rubber band; there is only so far it can stretch. In March 2021 valuation dispersion was at its 98th percentile relative to the past 50 years i.e. it has only been more stretched 2% of the time. If valuation dispersion does normalise from here, value investors will significantly outperform growth investors and this makes us very optimistic about the outlook.”
David Eiswert, T. Rowe Price Global Focused Growth Equity
“We see the extremes of growth and value as being relatively crowded. We believe that differentiated research, imagination and a gently contrarian spirit are principles that will be required in the next stage of the cycle.
“In our view, we are increasingly leaning towards a Goldilocks scenario where we have lower inflation (than today) but higher rates (although still historically low). This is driven by three factors: a significant slowdown in the Chinese economy as reform and regulation is implemented when it can be i.e., during the current period of high growth; the acceleration in Covid cases from variants slowing economic recovery; and continued progress in improving supply chains.
“Today, we are underweight I.T. as a result of our stock insights. There are several segments of the portfolio where we are being carefully contrarian. We are particularly searching for growth assets that are out of favour now, but where we see solid growth in 2022 and beyond. This includes some travel-related names. We also believe that it is worth exploring China’s regulatory changes and opportunities it may create – albeit with prudence. We have been selective with companies that we think have “crossed the chasm” in Covid and expanded their addressable markets and opportunities.”
Douglas Brodie, Baillie Gifford Global Discovery
“At Baillie Gifford, we state our own style clearly as growth, by which we mean searching for companies which can meaningfully grow their earnings over the next five years and beyond.
We believe the world is experiencing an acceleration in the pace of change and disruption. This is increasingly leading to winner-takes-all dynamics, with a handful of companies being the big winners. In this changing world we don’t believe the core tenets of value investing continue to hold true.
“Over the past decade we’ve seen new technologies dramatically change the dynamics of large industries, such as advertising and commerce. Yet, there’s reason to believe this is only the start. The convergence of new technologies, such as artificial intelligence, cloud computing and robotics, combined with cost reductions of key hardware components, such as lithium-ion batteries and transistors, mean we could be entering a new technology supercycle of innovation.
“We often observe that it is the smaller, nimbler businesses which are at the heart of driving change, while our experience of running the fund for a decade tells us that it’s only a handful of truly special businesses which go on to be the big winners, and so drive the majority of investment returns. Our investment philosophy therefore remains focused on identifying these businesses early and holding them for the long term as they scale.”