Value is not the best place to be given the current investment backdrop – but neither is pure growth, according to EQ Investors’ Kasim Zafar.
Zafar, who is a portfolio manager at the boutique wealth manager, said the team has reduced its Best Ideas portfolios’ exposure to pure value strategies and to those that are merely high growth.
Instead, the best place to be in this late-cycle stage is quality growth, a style that performs well across different economic environments.
“The time for value is not now, not in the US market where we are getting to that late stage of the economic cycle. It makes sense to reduce growth and to increase your quality growth exposure,” Zafar said.
“Our analysis suggests it makes more sense to top up your quality in terms of equity. These are companies that have got strong balance sheets, high returns on equity and predictable earnings, which is the definition of the quality style.”
Performance of value vs growth since 2007
Source: FE Analytics
The recovery since the global financial crisis of 2007-2008 has been characterised by growth or momentum trades, with investors betting heavily on companies whose earnings are expected to grow at an above-average rate compared to their industry or the overall market.
Despite a brief period when the trend was reversed in 2016, value stocks – or companies that remain unloved by markets – have lagged their growth peers for the past decade.
Over the past few months many investment debates have revolved around these competing investment styles, with investors trying to time the value cycle and wondering when this style will eventually make a comeback.
As we approach to the end of the economic cycle and the US Federal Reserve continues its policy of gradual rate rises, many experts believe value will eventually regain traction.
However, there are also some who argue the strategy that focuses on stocks trading at less than their intrinsic value won’t make a striking comeback.
According to Zafar, being overweight growth versus value is no longer the right place to be, but neither is pure growth. The reason has to do with the four stages of the economic cycle – expansion, peak, contraction and trough – and the performance of the different equity investing styles during these.
“When anyone talks about growth versus value nine out of 10 times I see them talking about the relative performance of growth and value in the MSCI World,” he said.
“Sure, when you look at that relative performance you see value outperforming since 1962, with the exception of the post-crisis period and the exception of a few periods when value materially underperformed.
Performance of indices since 1995
Source: FE Analytics
“However, when you look at the MSCI US Growth index and the MSCI US Value index – which are the growth and value indices only for US equities – you don’t see that picture at all.
“What you actually see is the value style in terms of excess returns versus growth excess returns in a long-term 40-year drawdown with the exception of two periods: the first one is a collection of times when value massively underperforms, which is when growth massively outperforms i.e. the peaking phase of equity market cycles.
“And the time when value massively outperforms is not because value is doing very well but because growth is massively underperforming: that is when we are going through market crashes.” 
For all of the time periods, Zafar (pictured) said value persistently underperformed growth since 1962 with the exception of the period between 2001 to 2007.
However, he noted what made that time period different was that the two industrial sectors that are traditionally considered as value sectors – financials and energy – had massive tailwinds behind them.
“In the case of financials, it was because the banks were levering up and you had the securitisation crisis so bank profitability was massive, which is why a traditional value sector did well,” he said. “My guess is that this led to the outperformance of value as a style.”
“And the second one is when we had the commodity boom [during the early 21st century] that benefitted not just to the energy sector but materials as well,” noted the EQ investors’ portfolio manager.
In all other periods, Zafar said value has actually been underperforming with a very clear exception: when equity markets crash.
Stock market crashes are a rapid an unanticipated drop in stock prices and, although they can be a side effect of catastrophic events or economic crisis, they can also occur when the stock market is vastly overvalued to fundamentals.
When market crashes and the price drops, the price of undervalued stocks tends to not fall as hard as that of overvalued companies, leading to an outperformance of value as a style.
“When we saw this, we said ‘okay, owning value in the US doesn’t make sense unless you can time when growth is going to crash’ and I don’t know many people who are able to do that,” said Zafar.
He noted the team looked at a variety of factors and the quality factor was the one they found was robust across different economic environments.
He said: “Depending on which of the four stages you are in we look at how styles performed and what we found is that the quality as a style performs very well across most.
“It does very well in the peaking phase and the recessionary phase of the cycle meanwhile growth as a style does incredibly well in the expansionary phases and the recovery phases and does okay in the peaking phase but does horribly in the recessions
“So, if that analysis is taken as truth then if we are worried about getting late cycle then it makes sense to reduce all our exposure to high growth; but unless you believe that we are going into a recessionary environment, it doesn’t yet make sense to make a full style tilt into value in the US market.”