Growth vs. Value: Does the Rotation Have Legs?
The outperformance of growth has been as stark as investors have ever seen. As the great debate of Growth versus Value rages on, the question facing investors is why the relative performance of growth has been so superior of late, and whether they can extrapolate this trend over the next decade despite the improving backdrop for value.
Figure 1: The Outperformance of Growth, Post-GFC
Value investing is often defined as the process of determining the value of a future stream of cash flows and acquiring the rights to those cash flows at a discount to that value. Many disputes the merit of this age-old definition, however, contending that it connotes that ‘growth investors’ seek not to pay less for an asset than it is worth – which contradicts the very meaning of investing.
No less than the Oracle of Omaha, Warren Buffett, concurs, stating that “consciously paying more for a stock than its calculated value… should be labelled speculation [not growth investing].” Rather, growth investors too seek to buy equities at a discount to their intrinsic value, but their view on how that is consistently achievable, differs from value investors. Growth investors often adopt the view that the market on average underestimates the durability of the earnings growth of particular high-quality fast-growing companies, and therefore, they often have higher than consensus forecasts of future free cash flow. Therefore, such growth investors often discover companies trading at a discount to their calculated intrinsic value, despite the stock in question trading on high traditional valuation metrics (such as price-to-earnings ratios)
A prime case of this phenomenon is Amazon. Despite appearing expensive on traditional valuation metrics for the better part of the last decade, growth investors that understood that short-term multiples failed to capture the value inherent in Amazon’s tremendous long-term growth trajectory have been rewarded with mind-boggling shareholder returns. The magnitude of the opportunity for Amazon meant that despite its sheer size, its growth rate did not mean revert as many initial bears expected.
Figure 2: Amazon’s Explosive Shareholder Returns
Establishing a Clearer Distinction Between Value and Growth
Value stocks can be thought of as those that demonstrate characteristics such as low price-to-earnings ratios, price-to-book ratios, and which trade on a relatively high dividend yield. These companies tend to operate in mature, old-age industries such as traditional energy.
Growth stocks on the other hand can be thought of as those companies that trade on an above-market price-to-earnings ratio, and which are typically growing at relatively higher rates. These growth companies can be thought of as to belong in either of two categories, “moat businesses” and “disruptors”.
“Moat businesses”, also referred to as “quality”, are those new aged companies such as realestate.com in Australia or Amazon in the US that have built up their market dominance over time and are therefore able to generate consistent above market growth in EPS. Disruptors on the other hand are younger businesses that are aggressively investing to take market share and are often yet to be profitable. Investors justify paying eye-watering multiples, which tend to be on revenue rather than earnings, for the prospect of high free cash flow in the future.
The Superior Investment Style: What Does History Suggest?
Value meaningfully outperformed Growth in the 20th century, however the last decade has proved to be an uphill battle for value-oriented fund managers, with value dismally underperforming its growth counterpart (Figure 3).
This has been primarily attributed to the structural decline in interest rates that have been symptomatic of a sluggish, late-cycle global economy.
The argument follows that because growth equities’ forecasted cash flows are skewed further into the future, that is, they are ‘long duration assets’, their valuation is more sensitive to a decrease in the cost of capital of a firm, of which the risk-free interest rate is an input into. Therefore, a fall in the risk-free interest rate, in theory, disproportionately benefits the valuations of growth stocks when compared with value stocks. This relationship between the risk-free rate (e.g. real 10-year US treasury bond) and the outperformance of growth is demonstrated in Figure 4 below.
Is There More to Growth’s Recent Outperformance?
Despite the influence of a meaningfully lower risk-free interest rate, investors cannot ignore the contribution to growth’s unprecedented strength by the structural global shift to digitisation.
The last 20 years has seen companies such as Amazon, Microsoft and Facebook become household names, as their disruptive business models have revolutionised the way we live our lives. The technology sector is simply not what is was in the 20th century.
Unlike the dot-com bubble, these companies now have free cash flows to go along with their exciting stories. While value sectors such as traditional energy have simultaneously faced structural and cycle-related headwinds, technology and healthcare names have been rewarded for consistently growing above GDP and adding great value to society. This has resulted in technology substantially outperforming other market sectors, which appears to have meaningfully contributed to Growth’s outperformance (Figure 5).
Where to next?
Value investors profess that the time is now that the trend will reverse. Accelerating inflation and the prospect of a global economic expansion are all compelling arguments for why value will have its time under the sun. When growth is less scarce, it is plausible to expect that valuations on high growth names may compress.
More prominent has been the argument that rising yields will threaten the lofty valuations of Growth names. However, analysis conducted by Schroders concludes that it is likely the speed of the move up in the real 10-year treasury yield (a proxy for the risk-free rate on assets) is more important than the move itself, asserting that “value has on average outperformed when real yields have risen by more than 2 standard deviations… [but less than that] relative returns on average have been flat.” This may explain the sharp outperformance of Value since the start of the year following a dramatic move up in the U.S. 10-year bond, depicted in Figures 6 and 7 below.
Irrespective of the debated impact if risk-free rate proxies were to move higher, history would suggest that given the differential between the valuations of value and growth, growth is set to underperform in the current decade (Figure 8).
While all evidence points to the possibility of a near-term outperformance of Value, the structural dominance of Growth names will render it difficult for investors with a strict preference for traditional, mature, low multiple businesses to outperform beyond the medium term. A tactical weighting to economically sensitive Value names as a play on the global recovery thematic over the medium term will likely reap rewards for investors. Beyond that however, being underweight innovative, technology-centric companies will deprive investors of the astronomical ‘multi-bagger’ shareholder returns that ensue from being on the right side of change.
Peter Cotsopoulos is a Research Analyst at UNIT (University of Melbourne), whose work primarily focuses on the macroeconomic forces influencing financial markets.
Edited by Samuel Subramaniam
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.