Many believe that the aggressive rotation out of quality-growth stocks towards the value investing style has much further to run, leading investment specialists to warn that the quality-growth funds that have topped performance tables could start to struggle.
Since the global financial crisis, the growth style has significantly outperformed value on the back of factors such as nervous investor sentiment, ultra-loose monetary policy and, more lately, concerns over deflation.
As the chart below shows, the MSCI AC World Value index has lagged MSCI AC World Growth over the past nine years by more than 20 percentage points.
Performance of indices over 9yrs
Source: FE Analytics
However, things are much different over 2016 to date. As investors started to focus more on reflation and grew nervous about the high valuations of quality-growth stocks (especially those deemed to be so-called bond proxies), value began to outperform.
FE Analytics shows that the MSCI AC World Value index is up 31.84 per cent in sterling terms over 2016 so far while the growth index has made just 20.52 per cent. The outperformance of value has intensified since mid-September.
Ian Heslop, head of global equities at Old Mutual Global Investors, argues that the markets are moving into a new environment, where investors need to get used to assets and funds that have performed well in the past not doing so well in the future.
“Concentration at style level – which we've had through quality-growth with a bond proxy flavour – has been playing almost uninterrupted for three years. This is a start of an unwind, it's not the finish. It might flip-flop around but there's a long way to go in this rotation,” he said.
“This trade that's unwinding, if you take it back far enough, it goes to the global financial crisis. For eight or nine years, the same trade has through all global markets so 10 weeks of movement is not an 'unwinding'. There’s a huge amount of money to unwind.”
Data from Bank of America Merrill Lynch’s closely watched Global Fund Manager Survey recently highlighted the strong short-term move towards value, showing that there was a significant shift towards value/reflationary sectors like commodities and banks over the past month.
Month-on-month changes to global fund strategy positioning
Source: Bank of America Merrill Lynch
The research also looks at the current longs and shorts relative to history that are being seen in fund manager portfolios. Funds are long banks, industrials, commodities and materials; shorts are now being seen growth areas like consumer staples, telecommunications and healthcare.
When asked if they think the rotation to cyclical styles and inflationary sectors will continue “well into 2017”, some 54 per cent of fund managers agreed. Less than 15 per cent believe the rotation is already over.
Heslop is one who thinks the rotation has much further to run. He says the election of Trump can be seen as a catalyst for the recent value rally, but long-term drivers such as rising wages in the US and the difference in relative valuations between the two styles can fuel a long-term run.
“The valuation differentials between value and quality-growth stocks have got very stretched and we have started to see the outcome of that over the last two-and-a-half months, where funds that are very exposed to bond proxies have not had a very good time while value-type companies have performed exceptionally well,” he said.
“Remember, we've had a long period when value has underperformed. Picking stocks in relation to how cheap or expensive they are has not been a good thing to do. Quality-growth, bond proxies, that has effectively been the only game in town. What we're seeing now, as will always happen, is a rotation. The funds that have performed exceptionally well up to this point aren't performing as well now because the environment has inherently changed and will continue in that frame.”
Joshua Ausden, head of client investment strategy at Neptune Investment Management, is concerned that investors have focused so much on earnings risk over recent years – seeking out quality businesses with reliable earnings – that they have forgotten price risk and found themselves holding companies that have been bid up too far.
“We think price risk has been shown to be more important than earnings risk over the long term. If you look at something like the dotcom bubble, that was essentially a price risk event which resulted in that massive sell-off,” he said.
“Microsoft, for example, had very strong earnings growth over that period but got so expensive that it sold off aggressively. I think we're starting to see that now with companies that have been bid up so high during this low interest rate, low inflation environment. If look at Novo Nordisk, which is one of the most owned companies by European fund managers, the share price is down about 40 per cent this year which is more than most of the Italian banks. It's not seen as a risky company but these are some of the share price moves you can see when companies are bid up too high.”
Historic value bear markets
Source: Fama-French Growth and Value Series (Ibbotson), Strategas August 2016
He points out that value investing has a long history of outperforming growth and has only underperformed on a handful of occasions, such as after the Great Depression and the bursting of the dotcom bubble, as shown above.
“When you look at the margin of outperformance that we've seen over the past seven or eight years, the quite aggressive rotation of the past couple of months hasn't really made a dent in the gains of those seven or eight years. If you look at the valuations of some of the quintessential value sectors – the European banks being an obvious one – they're still incredibly cheap, trading below book value while paying attractive dividends,” Ausden said.
"We expect this to continue. Not necessarily in a straight line, there will be periods of volatility – especially as investors have already had some pain in these value sectors. But looking at where the risk/reward is now, we would still very much say that there is a long way to go in some of those value companies.”
In a coming series, FE Trustnet will ask investors which funds they think should be held alongside some of those that have already made strong returns on the back of the quality-growth rally.