The Growth vs Value Debate
The above left chart is often used to argue that growth is excessively stretched vs value. Some argue this is more extreme than during the dot-com bubble of 2000. We believe this view is misguided for several reasons. Firstly, value stocks have significantly higher dividend pay-out ratios, so at the very least the chart should be adjusted to total return (above right). This reduces the outperformance for growth over the nearly 25 year period from 76% to a less significant 27%. However just looking at historical price performance and expecting a mean reversion seems naive. A more informed view has to consider some of the drivers of price.
Bringing earnings into focus.
In the long run earnings drive price, and looking at the above charts the growth index trades at a current p/e ratio premium of around 67.5% and an estimated premium (next 4Q) of 49%. These are reasonably close to the 25 year average of 46% and 35%, and way below the dizzy heights of around 350% and 270% during the dot-com bubble peak of 2000.
Return on common equity.
The above charts show one of the quality factors we monitor- Return on Equity. As we can see the growth sector has experienced a growing and more stable ROE profile, and is at a much higher rate. (Currently 29.2% vs 6.3%) While the value sector has been on a more volatile and cyclical downward path. Given this backdrop maybe the 14% premium for growth over value’s 25 year average Est P/E ratio is warranted.
What about academic research suggesting long run value factor outperformance? Again, one has to dig deeper and look into the current index and identify the drivers. The main difference in sector weightings is that the Value index is dominated by Financial and Energy stocks. The macro environment for these two sectors has been very poor. Zero rates, flat yield curves, higher regulation and less leverage have adversely affected the Financial sector performance. While a global push for renewables is providing negative headwinds for the Energy sector. It is hard to argue that these themes will change in the short run. Clearly these macro factors explain a lot of the value underperformance which a one dimensional price chart cannot. Conversely growth now has a lower discount factor for future cash flows, and has experienced a lockdown boost to demand. One can see that these may dissipate somewhat next year. However considerations such as accounting practices for intangibles and share repurchases have also likely altered the constituents of the respective indexes over time and make a strong view more difficult.
Our view is that we don’t think the current growth/value spread is anything like the historical extremes of 2000. In fact, when looking at the significant benefits of growth over value, earnings multiples and the macro drivers over the post 2008 period, we think the spread is probably closer to fair value than overvalued.
However, regardless of the future path, at Nutshell we prefer a bottom up approach and will invest where we think the best long run risk adjusted return lies. We are flexible and not pigeonholed to value or growth. We invest in a concentrated portfolio of exceptional companies at reasonable valuations. Companies which already have a proven track record, wide moat and offer “value” given their individual set of favourable characteristics. (Interestingly our bottom up approach has led to a recent increased exposure to the Technology sector, with Tencent and Qualys entering our Top 10). 2021 is likely to be characterised with a continued tussle and debate between growth and value. We prefer to stay focused on holding quality companies at reasonable valuations, rather than a top down macro allocation to either value or growth.