After more than a decade of underperformance from the value style of investing, the last few months has seen value stocks finally outperform growth.
Investors now need to determine whether this will lead to a prolonged outperformance of value stocks – such as was seen after the ‘Nifty-Fifty’ and ‘dotcom’ booms went bust – or if it is just a short spurt that will soon peter out.
Unfortunately for die-hard value investors, there have been several times in the last decade where value began to rally but didn’t materialise into a decisive return.
Periods since the 2009 Global Financial Crisis when MSCI World Value outperformed MSCI World Growth
Source: Capital Group, Refinitiv
In the past, when value stocks have experienced negative earnings growth, the value premium has usually stayed positive due multiple expansion. However, after the global financial crisis of 2009 this pattern has not repeated.
Instead, Nisha Thakrar, investment director at Capital Group, observed that two changes have prevented the value premium from materialising.
The first change is value’s weaker earnings growth. She said: “Earnings growth for value stocks was stable historically, but over the last 20 years it has become less persistent and more volatile relative to that of growth stocks.”
The second change has been growth’s higher valuations. “Valuation spreads have increased significantly and in 2020 reached the extreme end – the 100th percentile – similar to the highs seen during the tech-bubble,” she explained.
Looking back, she gave four fundamental reasons why this has been the case and why this could pose a growing risk to the value-growth investing framework.
Value-heavy industries have been in secular decline
The first reason is because banks, energy and utilities are three value-heavy industries that face major headwinds that are “unlikely to reverse” after an economic recovery.
Banks have suffered from sustained low interest rates lowering bank margins and tighter regulation scaling back their previously highly profitable trading activities in the name of financial stability.
“As banks look to diversify their revenue streams and build-out digital capabilities, they will need to get past new and more agile competition – notably fintechs – to become long-term winners,” Thakrar said.
Energy companies have also been hit by a perfect storm of Covid-related demand reduction, depressed oil & gas prices, reduced cashflows, production declines, a 13-year low in exploration & production capital expenditure and high dividend-payout ratios.
Meanwhile, the utilities industry has experienced flat aggregate demand, weaker wholesale prices and a shift towards distributed power generation over the last decade.
“Growing demand for renewables has resulted in the rise of wind- and solar-generated power,” Thakrar added. “All of which has meant many conventional utilities have been laggards, given their slower pace of change towards decarbonisation and electrification.
“As the industry converges and sees ongoing disruption, the key will be finding companies who prioritise clean power and incorporate digital strategies to adapt meaningfully.”
Digitisation has divided winners and losers
The second reason for value’s underperformance is because of how digitisation has brought major secular change across industries.
“Some firms have begun to take advantage of these new technologies and are already transforming, whilst others have lagged,” Thakrar explained.
“As digitisation grows, industry boundaries may become blurred.
“Firms that have already begun diversifying outside of their main industry have seen their revenues grow 25 per cent higher than the sector average, which highlights that disruption and innovation aren't confined by value and growth labels.”
She highlighted the “deep economic moats” of companies like Amazon, Alphabet and Facebook as well as their ability to recognise network effects, or situations where increased numbers of users improve the value of a good or service – such as e-commerce or social media.
Industry composition has narrowed
The third reason for a lack of value outperformance is because value and growth stocks have seen a concentration of industry make-up.
She highlighted how some industries today are almost entirely made up of value or growth stocks.
“For example, banks have remained dominant within the global value index over the last 20 years, shifting from 16.0 per cent to 10.7 per cent,” she said.
“However, within the corresponding growth index, they have collapsed to just 0.2 per cent (from 2.5 per cent).
“Conversely, technology hardware has risen to become 9 per cent of the global growth index (previously 5.1 per cent) while remaining below 1 per cent of the global value index over the last two decades.”
This makes diversification within investment style more difficult, and it also means that industry-wide secular changes are becoming more important for returns than growth or value labels.
Growth in intangible assets has made determining intrinsic value increasingly complex
The fourth reason for value’s underperformance is due to the rise in intangible assets, which has made it difficult for investors to understand a firm’s intrinsic value.
Intangible assets are typically non-physical and non-financial, like brand, customer loyalty and research & development (R&D). Whereas tangible assets are physical, such as warehouses and equipment.
“Despite both being significant to understanding company valuations, accounting rules treat internally-generated intangibles differently, resulting in distorted book value and earnings,” Thakrar explained.
“As many of these items are difficult to measure, not included on financial statements and require different amortisation methods to reflect their alignment to revenue contribution, a quantitative assessment will not suffice.
“This doesn’t make traditional valuation approaches useless, but does mean investors need to make adjustments to determine true value.”
Looking forward, Thakrar expects that intangibles are probably going to become a larger component of many firms’ assets as technology continues to infiltrate industries.
As such, “a classic value–growth framework that separates stocks based on valuation metrics which do not fully capture how a company creates value, is not helpful to investors searching for long-term winners,” she said.
Instead of trying to time a value resurgence, investors should look across the whole universe of both value and growth to select stocks.
“One illustration of this is the connected health and fitness industry – where new technologies are beginning to shape every aspect of sport: data, performance and the user experience,” Thakrar said.
Highlighting Nike’s new fitness analytics and Peloton’s streaming spin classes, she said: “An old economy stock like Nike has transitioned into the new economy, transforming its revenue growth and thus becoming a growth stock.
“Similarly, Garmin, a value stock (with low valuation multiples despite strong fundamentals), has pivoted its business model towards smart wearables.”
“Examples such as these demonstrate that potential future winners can be found in both value and growth,” she finished.