Much has been written about the current switch from Growth to Value, but what does it all mean?
How does one define Growth and Value?
The following are the “Key Takeaways” from www.investopedia.com.
• Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book Value.
• Value investors actively ferret out stocks they think the stock market is underestimating.
• Value investors use financial analysis, don’t follow the herd, and are long-term investors of quality companies.
Value investors look at ratios such as Price to Book value, Price Earnings, Price to Cash flow and dividend yield.
The key takeaways, again from Investopedia
• Growth investing is a stock-buying strategy that focuses on companies expected to grow at an above-average rate compared to their industry or the market.
• Growth investors tend to favour small, young companies poised to expand, expecting to profit by a rise in their stock prices.
• Growth investors look at five key factors when evaluating stocks: historical and future earnings growth, profit margins, returns on equity, and share price performance.
• Ultimately, growth investors try to increase their wealth through long- or short-term capital appreciation.
Growth investors focus on ratios such as margins, return on equity, return on capital, PEG Ratio, (Price Earnings to Earnings Growth), price to sales.
My simplified take:
Value Investors like finding stocks that the market is valuing at 50p but are worth 100p. Worth a 100p because perhaps, it has net assets of 100p or it is valued at only a half of the market price-earnings ratio or it has a dividend yield twice the market average.
The fact that in five years it might only have increased in “worth” to 120p doesn’t matter. There is an immediate opportunity to double one’s money as it gets back to “intrinsic value”. There is also a chance that the market is being too pessimistic and that it is worth 150p in five years, not 120p, in which case the upside is more significant.
Growth Investors, on the other hand, are prepared to pay 150p now for something that “intrinsically” might only be worth 80p. In contrast to a Value stock, it is probably valued at a considerable premium to book value, on a Price Earnings ratio twice that of the market or more and most likely does not pay much of a dividend. It chooses not to pay a dividend because it is reinvesting that spare capital in the business at a high rate of return.
A growth investor’s view is that in five years, the shares will be worth 600p or more, so the fact that they are paying 150p now is neither here nor there.
Risks with each approach:
The two main risks with Value investing are that the stock is at a discount for a reason and that the market takes a long time to come around to your point of view. In the first case, it does not, in reality, have an intrinsic worth of 100p. The company is performing poorly and maybe in a permanent downtrend. In the second case, one can get stuck with a company going nowhere for longer than one might have anticipated.
The main risk with Growth investing is that one pays too much. By paying too much, instead of paying 150p for the stock you believe will be worth 600p in five years, you get sucked in at 400p or 500p. The story sounds too good to miss, and perhaps FOMO (Fear of Missing Out) comes in to play. The second risk is that in five years it is worth only 100p as the growth one was anticipating does not materialise, in which case you lose money quickly.
Value investors believe there is less risk in their approach as they are buying stocks at a discount to intrinsic value, and thus the downside should be limited. Growth investors think Value investors are missing out on the opportunity to make real money by backing fast-growth companies.
Over the last five years would one have preferred to be invested in the classic Value stock, Imperial Brands or the FTSE 100 poster stock for Growth, Ocado?
The valuation differential between Value and Growth stocks became as stretched as it has ever been this year. Investors paid up for those companies which are growing fast because of or despite the pandemic. Investors also bid up stocks which were benefiting from technological change; take Tesla. Also, there has been ample liquidity available for investors to indulge their enthusiasm for Growth and no doubt FOMO has played its part.
Investors sold down Value stocks. Any company where business suffered due to COVID, technological or secular changes, found themselves friendless. The market collectively became gloomy about the outlook, doubting how fast any recovery would emerge. In short, “there is no price I’m prepared to pay for this company where I have doubts about its future, especially when I can invest in more exciting growth stories!”
Things had already started to change over the summer, but Monday 9th November was a significant turning point. The announcement of an effective vaccine was the catalyst that changed the balance of market opinion. There was a way out of the seemingly never-ending cycle of lockdowns. A strong global economic recovery in 2021 was likely. We would fly again, and we would go on cruises, stay in hotels, go shopping etc. At the margin, investors started to move from highly rated growth companies into Value Stocks.
In the UK the ten best performing FTSE Stocks between 9th November and 7th December were: Glencore +33%, Rolls-Royce +31%, Antofagasta +30%, International Consolidated Airlines +29%, BT +26%, Anglo American +25%, Royal Dutch Shell +25%, Lloyds Banking +22%, NatWest +21% and Imperial Brands +20%. All are companies which now had a real chance of recovery.
The worst stocks included names such as Homeserve -13%, Experian -11%, National Grid -9%, Just Eat Takeaway -9%, Unilever -8%, Rightmove -7.0% and Hargeaves Landsdown -7%. All stocks which stood, and still do stand at significant premium valuations to the market on account of their perceived stability and growth prospects.
In the US it can be best illustrated by the performance of the Russell 2000 Index of smaller companies.
The top chart is of the performance of the Russell 2000 since the start of the bull market in March 2009. The bottom graph shows how it has performed relative to the S&P 500.
The absolute bottom of its relative performance was in April this year, but one can see the shot in the arm it got on Pfizer Monday.
The chart below shows the Russell 2000 relative to the NASDAQ 100. First, it shows just what a stunning run NASDAQ has had since 2009 and that the relative outperformance of the Russell 2000 since it bottomed in September, has barely registered on the chart.
Where to next?
I think the switch to Value has further to run. The valuation differential between Value and Growth remains stretched, and we are in the very early days of what should be a strong recovery next year. Monetary and fiscal policy has been accommodative, to say the least, and is likely to continue to be so in 2021. Governments and central banks will not want to take any risks with the recovery. There is no appetite to return to the austerity of the past decade. The approach, in the 2020s, is likely to be to try and grow one’s way out of the deficit, and there will be greater tolerance of inflation.
Where do my sympathies lie between Growth and v Value?
I have some sympathy with Terry Smith (FundSmith) who used the following example in a recent presentation: Fundsmith took a basket of six Value stocks which were trading at relatively low PE Ratios at the start of 2015 and six Growth stocks.
He said that back in 2015 you might have thought there was a bigger opportunity from the Value basket given the cheap valuations, (mid-teens PE Ratios) and that buying the Growth basket on such eye-wateringly high valuations would be a recipe for disaster.
The result over the next five years was that the Value basket declined by 45%, (Value got cheaper), and there was little if any growth in the underlying companies. The Growth basket meanwhile was up 800% reflecting stellar growth in the six companies chosen for the exercise.
Ultimately, I invest to make money by compounding the value of my portfolio year over year. In the medium to long term, I believe the best way of doing that is by investing in companies that are growing turnover, are generating cash, and are achieving a high return on equity and capital. However, when it comes to individual stocks, I am wary of paying too much. I prefer a GARP, (Growth at The Right Price) approach, which is why I rarely pay over 20x earnings per share for a new position.
I also look to take a balanced approach. I don’t put all my eggs in either the Growth or Value basket.
I am also pragmatic, gaining exposure to very highly rated Growth or Themes, through the likes of the Wisdomtree Cloud Computing ETF, iShares NASDAQ 100 ETF, L&G ROBO Global Robotics & Automation ETF and Biotech Growth Trust.
A current example of a Growth/Quality stock that is being left behind with the switch to Value.
Games Workshop, which I stupidly sold in June has published two powerful trading updates in recent weeks. On 6th November it said that the Board’s estimate for pre-tax profits for the six months ending 29th November was not less than £80m v £58.6m last year. So yet again, significant upgrades to earnings forecasts. Just three weeks later, yesterday it followed up, revising its forecast to “not less than £90m profits” and declared a special dividend of 60p, in line with its policy of returning truly surplus cash to shareholders. Despite these two announcements and significant upgrades to full-year profits, the share price is down 14% since Pfizer Monday.
The fall in the share price might be the limit to the current bout of underperformance. However, despite earnings upgrades, (with probably more to come) there is a risk that while investors are focused on Value, Games workshop struggles to find new buyers. From my point of view, I’m hoping that the shares come back further and present me with an opportunity to get back in at nearer to 20x earnings. If it does, a huge sigh of relief, if not, there are plenty of other fish in the sea!
Conclusion: We are currently in a “Value Investing” sweet spot as recovery gets underway. This trend could continue for some months. Now the buying is indiscriminate, but I think it will require greater caution going forward. Some stocks will reward investors with a strong recovery in the underlying business, whilst others will disappoint as sales and profits do not recover as fast as anticipated.