Investors are likely to be rewarded for buying into sustainable growth stocks rather than value as we head further into 2016, according to Rathbone’s David Coombs (pictured), in spite of their already significant outperformance. 
The FE Alpha Manager, who runs the firm’s Strategic Growth and Total Return portfolios, says interest rates are likely to remain significantly lower than markets expect for a longer period of time and warns that Europe is at a greater risk of slipping into a recession than it was 12 months ago.
As such, he believes markets will put a price premium on both sustainable growth and dividend growth over the next couple of years given macroeconomic uncertainty. This is in contrast to some investors, who are eyeing a resurgence of value stocks.
The value versus growth story has attracted a vast amount of attention over recent months, given that the FTSE World Growth index has outperformed the FTSE World Value index over the last one, three, five and 10 years.
On an annual basis, the value index has only outperformed growth twice over the last decade – once in 2008 when the index lost 15.65 per cent compared to growth’s loss of 20.85 per cent – and in 2006 when the value index returned 9 per cent compared to the growth index’s 3.71 per cent.
Performance of indices over 5yrs
Source: FE Analytics
In an article published in December, Investec value team head Alastair Mundy said markets were in the throes of “value hell” given the number of macroeconomic headwinds on the horizon and toppy valuations across the board.
Many investors are now wary regarding the continual rise in the valuations of growth stocks though and are questioning whether their outperformance of value stocks is sustainable over the medium to long term.
“I don’t see markets going gangbusters but I think sustainable growth will be rewarded with a higher multiple over the next couple of years,” Coombs said.
“I think there are a lot of value companies that will struggle to provide any growth and I think if companies disappoint they’re going to be savagely marked down by the market.”
“This has already happened to a number of stocks, including Next recently, and I think we’re going to see a lot more of this so I’m looking for sustainable growth through large-cap US companies rather than European companies.”
While the US market has been criticised by UK investors for being expensive and mature, Coombs says that it is worth paying for higher quality given current market volatility.
He also points out that he is focusing on sustainable growth as opposed to high growth and therefore holds well-known brands such as Johnson & Johnson, Coca Cola and Visa, arguing that there is still growth left in the US given high levels of employment and strong job growth.
“My growth portfolio is in more expensive areas of the market and that doesn’t particularly feel comfortable, but it doesn’t mean it’s wrong either. Maybe the market is just willing to pay up for quality,” he said.
“I think what’s really happening is it’s willing to pay for transparency and willing to pay for visibility and I think that’s the key for me. It’s the visibility of that growth and it’s the sustainability of that dividend.”
Another reason that Coombs gives for investors’ recent aversion to growth is that they often subscribe to the mean reversion theory, which argues that returns will eventually move back towards their average after a prolonged period of outperformance or underperformance.
However, he says this can easily lead people into buying value traps without having a well-reasoned argument as to why to buy into this area of the market.
Charles Younes, research manager at FE, agrees that the premium in the growth space is justified as we are not yet at the end of a cycle and value stocks are only likely to outperform during the recovery stage.
“The dispersion in performance between UK value and growth stocks is at its highest point since 2000. Generally, value only outperforms during the early stage of the business cycle when investors are willing to take more risk,” he explained.
“When some people are allocating to stocks they want to take more risk, but now in this kind of cycle, valuations everywhere are a bit high.”
“When a stock is showing signs of growth and shows that it can improve its margin and improve its revenue, it should outperform.”
He adds that typical value indices have a strong sector bias towards areas such as mining and oil & gas, which is another reason for their underperformance.
As a result, Younes says if oil and commodity prices recover so will value, but he adds that this is a risky bet given the short window that value stocks have to outperform on a medium to long-term view.
“Value only outperforms over very long-term time frames. If you look over five or 10 years, value can outperform growth but can only outperform over short periods of time – value makes all of its outperformance over five to 10 years in just six months,” he explained.
“If you miss that rally, don’t expect it to come back any time soon because you’re always too late to the table if value is already outperforming. It’s really hard to time a value cycle and you therefore have to be patient.”
Despite this, the research manager says it is important to hold at least some value to maximise portfolio diversification.
For the time being though, both he and Coombs believe that growth stocks still have further to run.
“I think we’re in for two-to-three years of below-par global growth and I think for value to really start to outperform we need to see stronger growth in Europe and we need to see stronger growth in Asia. I don’t see the catalyst for that at the moment,” Coombs explained.
“What would change my mind is if I saw sentiment in China turn around, if Greece doesn’t rear its ugly head again this summer which I think it might well do and if Europe suddenly started to turn the corner.”
“I might then change my view but at the moment I think global growth will remain subdued, interest rates will remain subdued and therefore the markets are going to look for companies that can actually grow – that’s what equity investment is meant to be about.”
“We could be in for another three years where value underperforms – there’s not rule to say that just because it’s outperformed over the last three years that it won’t outperform over the next three years.”
Since Coombs began managing money for Rathbones in 2009, he has delivered an average total return of 61.98 per cent, outperforming his peer group composite by 12.22 percentage points.
Performance of manager vs composite
Source: FE Analytics
He has also achieved a lower annualised volatility, a higher risk-adjusted return and a smaller maximum drawdown – which measures the most money lost if investors bought and sold at the worst times – over the same time frame.
