It is impossible to predict when the value style will start to outperform, according to one US value manager, although investors need to be aware that some of growth’s biggest names are entering “uncharted territory”.
During the 10 years since the global financial crisis, the growth style of investing – or picking companies with above-average growth – has significantly outpaced value, or looking for cheap stocks with a turnaround story.
FE Analytics shows the Russell 1000 Growth index (which covers US large-cap growth stocks) has posted a 367.53 per cent total return, compared with a 236.38 per cent gain from the Russell 1000 Value.
Performance of indices over 10yrs
Source: FE Analytics
The outperformance of growth has been attributed to several factors, including the impact of ultra-loose monetary policy, the rise of disruptive ‘superstar’ companies, especially in the tech space, and investors jumping on momentum trades.
Heather McPherson, co-manager of the $1bn T. Rowe Price US Large Cap Value Equity fund, said: “Over the past decade, value investing has endured one of its deepest droughts of underperformance relative to growth investing.
“This shortfall has spanned market capitalisation and geography – engulfing small to large companies throughout developed and emerging markets around the globe. This begs the question: Is value investing dead or poised for a revival?”
McPherson noted that value has outperformed growth over the very long term, although its performance tends to be “somewhat cyclical” – and raises the question of the timing of any reversal in its fortunes.
However, she conceded that the short answer to this question is: “It’s impossible to predict when the trend may reverse.”
The manager added that investors have tended to rotate towards value when the valuation gap between the styles has reached extremes and concern grows that the growth leaders will not sustain their momentum.
“Interestingly, despite the superior performance of growth stocks over the past decade, the valuation dispersion is not abnormal,” McPherson continued. “At the end of November2018, the Russell 1000 Value index 12-month forward price/earnings [P/E] ratio was 0.74x that of the Russell 1000 Growth index, slightly below the relative average P/E since 1978.”
That said, value has underperformed growth by almost two standard deviations relative to its average 10-year performance over the past decade (based on 10-year rolling periods starting in 1926). History has shown that following periods of such extreme dispersion between value and growth, the odds of value outperforming over the subsequent three to five years are more than 70 per cent.
Value vs growth between Jan 1979 and Oct 2018
Source: FactSet, T. Rowe Price
The T. Rowe Price manager said: “While there are no apparent signals to indicate when the relative performance trend may reverse, investors should be aware that such reversals often happen very abruptly and tend to be extreme.
“It's difficult to accurately time a reversal, but relative valuation is often the catalyst and in some sectors we are getting close to such extremes. Moreover, to the extent there is higher inflation and a rising interest rate environment, some commodity and other cyclical companies could become relatively more attractive – for the first time in a long while.”
One area of the market that has led the growth style’s dominance since the global financial crisis is the narrow group of tech stocks known as the FAANGs: Facebook, Apple, Amazon, Netflix and Alphabet’s Google.
While concerns have been raised about valuations in the sector, McPherson pointed out that profit margins and cash flows for many big tech firms are at or near all-time highs, which means their relative valuations do not appear to be extreme. This is especially the case after 2018’s sell-off, which centred around those names.
But this does not mean McPherson thinks the market will continue to back these growth stalwarts forever. She sees potential catalysts for investors moving away from them and towards value as we approach the end of the cycle.
“We should note that we are in uncharted territory in terms of how these huge tech companies and other high-growth companies will perform in a changing economic environment,” the manager concluded.
“Google and Facebook, for example, are very ad-centric. There are no previous cycles where such dominant companies had to adapt to a more sluggish economy that could undermine ad revenues.
“In the value sector, by contrast, some of the companies have been operating for more than 100 years, so it’s possible to understand how things have played out for these firms when the economy changed course.”
Performance of fund vs sector and index over 10yrs
Source: FE Analytics
McPherson has been a co-manager on the T. Rowe Price US Large Cap Value Equity fund since January 2015. John D Linehan and Mark Finn have been co-managers on the strategy since January 2003.
The team focuses on relatively high-quality companies that are trading below their intrinsic value, as they believe that valuation is the most important factor driving returns and outperformance in the long term rather than the level of earnings growth.
Top holdings at present include JPMorgan Chase, Microsoft, Wells Fargo, Pfizer and Total. It has overweights towards the industrials & business services, information technology and consumer staples sector, while being underweight real estate and consumer discretionary.
T. Rowe Price US Large Cap Value Equity has an ongoing charges figure (OCF) of 0.82 per cent.