A rotation out of growth stocks and into more value names appears to be overdue, according Columbia Threadneedle’s Richard Colwell, although it is far from clear when this will take place. 
One of the defining features of the bull market that has been in play since the end of the global financial crisis is the outperformance of the growth and quality investment styles. As the chart below shows, value investing has significantly lagged these kinds of stocks.
To recap, growth stocks have revenues and earnings that are expected to increase at a faster rate than the average company; quality stocks are those with consistent profitability, market-leading positions and low debt; and value stocks tend to trade at a lower price relative to fundamentals such as dividends, earnings and sales.
Performance of growth, quality and value investing over 10yrs
Source: FE Analytics
Columbia Threadneedle Investments head of UK equities Richard Colwell believes the strong outperformance of quality-growth over value cannot continue over the long term, as the “extreme positioning” in defensive growth is making a “sharp rotation” possible.
Colwell – who manages strategies such as the £4bn Threadneedle UK Equity Income and £340.5m Threadneedle UK Equity Alpha Income funds – argued that current market conditions are starting to look reminiscent of 1999/2000 as investors hunt out ‘new economy’ stocks.
“‘Party like it’s 1999’, ‘Let’s all meet up in the year 2000’, ‘Back to the future’… there are no shortage of cultural touchstones we can reach for as we consider current equity markets,” he said.
“Since the jitters of late 2018 we have seen a resurgence in demand for defensive growth. In the US this has principally meant 'Big Tech', but in the UK we have seen mega-cap commodity stocks take their place at the top of investors’ buy lists and dominate market leadership.”
The left-hand chart below shows that high yielding stocks across Europe and the UK (which the manager is using a proxy for the ‘old economy’) have only been cheaper once during the past 30 years. He noted that one occasion was in 1999/2000, which resonates s given the parallels with that period being seen today.
Meanwhile, the chart on the right suggests that the ‘new economy’ – represented by the profitability of new IPOs in the US – is currently seeing the same levels of optimism that it did some two decades ago. It shows that a high proportion of stock market floats are not profitable.
“At the turn of the century the global market’s appetite for growth also saw investors draw a line between stocks which represented the ex-growth, tepid ‘old economy’ and the dynamic, disruptive ‘new economy’ led by stocks predominantly belonging to the TMT [telecommunications, media and technology] sectors,” the Threadneedle UK Equity Income manager said.
Old economy versus new economy
Source: Columbia Threadneedle Investments, Factset/Morgan Stanley, MSCI Europe, 30 April 2019. Numis Securities, Topdown Charts, Jay R Ritter
“This year, just as back then, a dovish pivot from the Federal Reserve following successive hikes sent a signal to markets that low rates and cheap borrowing could be here to stay.
“And while the music’s still playing most people take the view that, in the words of another Prince, this time former Citigroup CEO Charles ‘Chuck’ Prince, ‘you’ve got to get up and dance’ – that’s even if more than four of every five companies coming to market is loss-making?”
But determining exactly how close the markets are to this music stopping is a “contentious subject”, Colwell added. Some believe that another rate cut by the Federal Reserve will extend the bull market, similar to how its dovish response to the Long-Term Capital Management collapse and the Asia crisis of 1998 led to another leg of growth.
“In assessing the present day, we believe we could be an hour closer to midnight than many would like to believe,” the manager added.
“An accommodative Fed may have kept the party going in 1999 but sowed the seeds for a painful hangover in 2000 with ‘old economy’ stocks benefitting from a dramatic rotation out of tech and growth.”
He pointed out that the S&P 500’s growth versus value premium surpassed its 2000-peak in April this year, while the ‘Buffett indicator’ (a measure of total US market cap as a percentage of US GDP) has approaching levels last seen 19-20 years ago. “We would argue these are two more indications that the elastic has become very stretched,” he added.
“In this we are not seeking to call the end of the current cycle, rather we hope this adds some context to our caution on the sustainability of the current consensus positioning. Could we be due a downturn reminiscent of the early 2000s where the US economic recession was relatively mild, but equity market rotation out of the ‘growth’ basket was violent?” Colwell said.
“We think the proliferation of passive and exchange-traded fund money in the market these days will only amplify the severity of any such event, given the ‘valve-like’ quality of passive fund positioning (money rushes in at speed … but try rushing out!). In the meantime, some naysayers are folding as the pressure of taking the opposing side intensifies up to the point of reversal – voluntarily or otherwise.”
When it comes to the UK stock market, money has flowed out over recent on the back of the uncertainty created by Brexit, even among the companies with high overseas earnings – which Colwell described as being “highly disproportionate to reality”.
Overall, the valuation of the UK market relative to the MSCI World index shows the country has not be as cheap for 30 years and has only been cheaper once over the past 40 years.
“This is an important area of value and has created opportunities for active managers – as has the blanket derating of ‘old economy’ stocks thought to be doomed to declining growth, or worse, by ‘new economy’ disruptors. We acknowledge that some of these companies have big structural issues, but should they really be priced for extinction?” the Threadneedle UK Equity Income manager said.
“In our view the answer is not black & white, but in fact grey. Instead, we would ask whether the market has punished a share price without giving due consideration to the resilience of the business or its ability to adapt.
“With the elastic once again becoming very stretched we think that, just as in the early 2000s, a marked rotation from growth into value is overdue. Our aim is not to predict the timing or the indeed the trigger, but to ensure our portfolios are best prepared to weather the turbulence and seize the opportunities when that moment arrives.”
Performance of fund vs sector and index under Colwell
Source: FE Analytics
Colwell has managed the Threadneedle UK Equity Income fund since September 2010, over which time it has generated a top-decile 135.49 per cent total return. This ranks the fund sixth out of 63 peers in the IA UK Equity Income sector.
The fund has an ongoing charges figure (OCF) of 0.83 per cent and is yielding 4.3 per cent.