23 Feb Can value continue outperforming growth, or are growth shares moving into “value” territory?
As published in FA News on 17 Feb, 2022 by Kyle Wales
Value shares – those companies that are underappreciated and thus typically undervalued by most investors – managed to hold their own during a volatile start to the year and when the rest of the market was losing ground.
This has seen the value versus growth debate rear its head again.
Growth shares (unlike value shares) are those companies expected to grow faster than the rest of the market. Thus, growth investors expect them to have the greatest return potential despite appearing expensive.
The MSCI ACWI Value Index and the MSCI ACWI Growth Index are good representations of how each of these camps is performing, and these show that the Value Index (flat for the year thus far) outperformed the Growth Index (down some 10% in January) by a wide margin.
Value stocks, however, have underperformed their growth counterparts for many years. Thus, the extent of the recent outperformance of value stocks may be exaggerated because it is calculated off a low base.
If one looks at how value and growth have performed over more meaningful periods (let’s take five years, a more appropriate holding period for equities), growth stocks would have to decline by a further 50% relative to value stocks for value stocks to merely equal the return of growth stocks over the last five and ten years.
While value investing had a good run in January and it’s tempting to follow the money, the reality is that the pure forms of both investing styles – value and growth – have their drawbacks.
Growth investors frequently fall into the trap of paying too much for the sexy stocks of the moment. Value investors frequently buy companies on high current earnings (or dividend) yields, only to see them whittle away because they face serious, sometimes existential, challenges.
For the longer-term investor who wants to buy companies at a reasonable price, as measured by the extent of their discount to their “fair” or “intrinsic” value, rather than timing the growth cycle or value cycle (growth shares and value shares tend to outperform at different times), these distinctions are also beginning to lose their relevance.
The value of any asset should be measured by the net present value “NPV” of cashflows attached to that asset. Investors should be relatively indifferent to a higher-yielding stock that is growing at a slower rate than a low yielding stock growing at a faster rate.
While value investors may steer clear of companies trading at high price-earnings (P/E) and price to book (P/B) multiples, these need to be considered in the context of future growth rates because the multiple a fast-growing company trades on can contract pretty quickly. Growth, in other words, has a “value” to investors, and the compounding effect of high growth rates should not be ignored.
By contrast, “reversion to the mean”, which refers to the tendency of share prices to return to their historical averages and is the cornerstone of many value philosophies, can only happen once before a replacement stock needs to be found for a portfolio. This has implications for the amount of research an investor needs to do and the extent of the times you need to sell and buy shares, increasing trading costs.
Growth stocks on the right side of a disruptive world
Part of the reason that value has outperformed growth has simply been that we are living in a world of disruption, and growth stocks have been on the right side of those changes. If anything, the rate of change in the world is more likely to increase than decrease – and this is the type of environment that favours growth rather than value stocks.
In the recent quarterly reporting cycle, the 20%+ sell-offs in Meta (Facebook) and Paypal have attracted much scrutiny. While some investor’s view this as a comeuppance for investors with a growth bent, a far more productive exercise is to interrogate whether investors are being offered attractive entry points into these shares after their recent sell-off.
Meta now trades on a forward P/E multiple (after factoring in broker downgrades and deducting share remuneration expenses) of 20X, but it is still expected to grow earnings 17.7% in 2022. This is despite competitive threats from Tik-Tok.
A compelling case can also be made for its earnings or “E” being low because all the costs of building the “metaverse” are in this number but little in the way of “Metaverse” revenues. Any success Meta has in this space thus constitutes a free call option for long-term investors.
In the case of Paypal, it has downgraded its revenue guidance for 2022 from 18% to 15-17%. Hardly a train smash, especially considering that management teams normally guide low. It mostly attributes this downgrade to macro factors like slower ecommerce growth (as the world re-opens post-pandemic) and the roll-off of Covid grants. Management asserts that its competitive position has never been stronger and has stuck to the guidance in its five-year plan of 20% per year (in year two).
While Paypal certainly does not trade on a low multiple (26X on a forward basis), this contracts to 13X three years out based on management’s guidance.
A rebound in the performance of value stocks was long overdue due to the massive underperformance of value stocks relative to growth stocks, but time will tell whether this outperformance can continue. Ironically, one of the largest obstacles to it continuing may actually be that post the recent falls in the share prices of so-called “growth” stocks, they may actually be moving into “value” territory.
 From 27 Jan 2017 to today