Today’s market conditions could create problems for those investing on the basis of value or growth, although there are other factors that can help them find potential winners, according to fund managers.
After growth stocks rallied in the immediate aftermath of the Covid-19 crisis, value stocks have begun to recover as the economy starts to reopen and over the past month or so have led the market by a decent margin.
Value as a strategy, however, has delivered anaemic returns over the last decade, with the MSCI World Value index underperforming growth by 8 per cent per annum.
Investors may think that this makes it the ideal time to buy into a value strategy, capturing the returns of a potential ‘reversion to the mean’ which appears overdue.
However, Ilan Chaitowitz, co-manager of the Nomura Global High Conviction fund, said before buying into value, investors need to understand what has driven this trend.
MSCI World Value vs Growth over 10yrs
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Source: FE Analytics
Chaitowitz explained that seemingly ever-lower long-term interest rates have “kept the weakest business solvent and thus stopped the traditional capital cycle from buoying the strongest”.
“Typically, a rebound in the cost of funding would hurt most those businesses with the weakest profitability and see them either folding or acquired by more resilient peers,” he said.
He points out that value investors have historically relied on this process of ‘creative destruction’ by buying very beaten-up capital-intensive businesses at the bottom of the cycle.
By buying them as they start to rebound and their industries recover, investors are rewarded as valuations mean revert.
However, Chaitowitz said, crucially, the low interest rate environment isn’t going away and this has “enabled firms that are insolvent to persist and crowd-out growth opportunities for more productive firms”.
According to the OECD, the number of these ‘zombie firms’ has increased dramatically since the great financial crisis of 2008-09.
Chaitowitz said one reason long-term interest rates have been kept low is due to population demographics as baby boomers retire.
“Elderly people are typically less productive and require more social support in terms of healthcare,” he said. “Higher dependency ratios across developed countries and China are set to weigh on growth over the next decade.”
“So buying value here seems to require a prophetic insight into interest rates when the broader market maintains a decidedly muted outlook,” he added, pointing to the $15trn of negative yielding debt that continues to grow.
Chaitowitz also cautioned investors who favoured buying growth, highlighting the valuation discrepancy between the two styles, which has exceeded the dotcom bubble levels of 2000.
He believes the “today’s technology disruptors are likely to face erosion of returns when their own capital cycle plays out”.
“The problem with growth stocks is that at current prices many may exceed the net present value of their expected future cash flows,” he said.
The manager said that even if economic outlook improves, these companies could “underperform markedly”.
“Whilst the powerful secular trends weighing on global growth look set to continue for many years to come, buying growth today is an exercise in swapping economic cycle risk with valuation risk”.
He concluded by saying investors should focus instead on quality.
“High quality companies do something differently, consistently well, that is hard to copy,” he said.
“They can typically sustain their returns for longer than the market appreciates and are less likely to suffer irreversible declines in profitability. The best of these have attractive business opportunities in which to reinvest their profits which makes the business’ scale, and gains for shareholders, compound over time.”
Stuart Rumble, multi asset investment director at Fidelity, said investors should focus on sector allocation rather than growth or value strategies.
Because a rebound in global GDP growth is still shrouded in doubt, he said it is “difficult to call a major rotation in investing styles just yet”.
Growth strategies, which typically favour the technology and healthcare sectors, have rebounded hard after the crisis.
While the technology sector has led the rebound and Rumble reckons this can continue, he believes the future performance of the healthcare sector “may not be so broad once the pandemic is over”.
“Many companies and businesses are being forced to explore new ways to conduct their businesses online, ranging from remote working, video conferencing to online shopping and payments,” he said. “Much of this heightened demand is here to stay.”
However, he said that while telehealth providers could benefit from the increasing trend of remote consultations as more physicians and patients become accustomed to virtual care visits, “sales of healthcare equipment and services could take longer to recover due to delays to elective procedures and vastly reduced treatment capacity”.
Performance by global sector over 3 months
Source: FE Analytics
Energy, a sector dominated by value strategies, has rallied heavily after indications of rebounds in economic activity in certain countries and a new agreement on oil production cuts amongst the OPEC+ nations.
Rumble argued that “there could be further upside to oil prices as the demand picture improves and global oil inventories gradually normalise”.
However, he believes banks, another sector favoured by value strategies, still face major headwinds.
“Net interest margins have declined, dividends have been cut and there is the potential rise in non-performing loans to come,” he said. “In this environment, bonds appear to be a much more appealing part of the bank capital structure.”