Is It Time for Value to Outperform?

Growth vs. Value

The debate over growth versus value is an old one. Is it time for value to outperform? So far this year, the iShares S&P 500 growth ETF, ticker IVW, has returned 16.97% YTD, whereas IVE, the value ETF, has returned 3.26%.

Growth stocks are companies that have a high potential for growth. They often have high price-to-earnings ratios, lower profitability, and reinvest revenues back into their business. Value stocks are companies that are often more established, have stronger balance sheets, less need for financing, slower growth, return part of their profits to shareholders. They may also have lower price-to-earnings ratios and low price-to-book ratios, just to mention a few.

During some time periods, value stocks prevail and at other times growth stocks prevail. Shortly after the 2016 presidential election value stocks went on a tear and produced excellent returns. Thereafter, the baton was handed to growth stocks and they have performed well in 2018. At this point, per Bloomberg, the valuation gap between the MSCI World Growth Index and its value counterpart has reached the highest since 2001.

As the graph shows – global growth shares are trading at 17.9 times forward earnings vs 12.9 for value stocks (source: Bloomberg).

Growth has become extended

In good economic conditions and low costs of capital, investors tend to pay up for growth prospects. After all, growth companies often trade on their expected future returns. These hopes may or may not materialize. The past is littered with growth companies that could not sustain profitability and no longer exist. When interest rates rise it affects the cost of doing business (i.e., borrowing rates) for many growth companies. Investors then adjust their expectations for future profits.

An essential component of a stock’s valuation also changes, which lowers the implied stock price. This component is called the WACC – weighted average cost of capital. It is the blended cost of debt and cost of equity to the firm. This measure of the firm’s cost of capital, the WACC, is the rate at which future cash flows are discounted to the present. Therefore, the higher the WACC (cost of capital) the lower the present value of the future income stream and the lower the implied price per share.

When companies’ cost of financing increases, the value of their stock price often decreases. Companies with less of a need for financing tend to fare better. These companies are better capitalized or they have longer-term financing in place. This allows them to keep their cost of operating at a more constant level and their profitability more consistent. The result is a more stable valuation

Business Cycle – Sectors

In later stages of the business cycle, as costs of capital start rising, consumer spending cools, and growth expectations come back down to earth, other sectors start to perform better. Fidelity produces a nice table that shows which sectors tend to perform better at the late stage of the cycle. Consumer discretionary and information technology are not in the mix. Rather, consumer staples, energy, healthcare, and materials start to perform better. We cannot say that all companies in these sectors will perform well because some are highly levered like growth stocks. On average, however, these industries do better because the majority of these companies are well capitalized.

How Should I Position?

It is a tricky time in the markets because we are not yet in a recession, the Fed is still raising interest rates, and company profits are still doing good. We do not seem to be at the point where consumer staples and utilities start to outperform (recessionary behavior) because these sectors react negatively to interest rate increases. We see growth stocks cooling off, but we also do not yet see value stocks taking over. The question is, which one will win?

The smartest and safest bet, we feel, is to stick with companies that have strong earnings, good balance sheets, are not overly levered (reasonable debt levels), and are in strong sectors.

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