At a high level, growth stocks are companies with a high expected earnings growth rate. Value stocks are companies that are cheap relatively to the rest of the market. While valuations for all areas of the market look expensive relative to their own history, Growth equities appear to have discounted a lot more good news and, therefore, there is scope for their value counterparts to play catch up.
It might sound strange, but growth stocks did extraordinarily well in 2020, despite the unprecedented recession. There are two main reasons for this.
First, the sector composition of the growth universe of equities could hardly have been better suited for the pandemic year, with almost three-quarters of the index coming from four sectors – technology, consumer discretionary, healthcare and communication services – which were the main beneficiaries of the Covid-19 outbreak.
Second, the collapse in interest rates and bond yields reduced the discount rate feeding into equity valuation models. This had a much larger impact when it came to valuing growth companies where the future earnings are expected to rise sharply and sustainably. Therefore, much lower yields meant sharply higher valuations could be justified. On the other side of the equation, the value style was hurt by its sector composition – with the two largest sectors being financials and industrials, while the weight of the energy sector is 16 times that of its weight in the rival growth index.
These sectors were amongst the worst hit by the sharpest recession on record (remember there was a bizarre day in 2020 when owners of crude oil were paying people to take it off their hands). So why do we think that value may outperform in 2021? We believe there are three key factors to watch when it comes to a potential pivot towards value – economic growth, inflation expectations and bond yields.
Stronger economic growth (above 3% in the US and globally) and rising inflation expectations and bond yields would be seen as supportive to value equities and detrimental to the growth style.
This may sound counter-intuitive, but in an environment of stronger global economic activity, the so-called growth equities lose their “growth” advantage. We believe economic growth will rebound strongly in 2021 as coronavirus cases peak and vaccine distribution allows for significant economic reopening. The exact timeline for this is clearly uncertain, as shown by early disappointment in vaccination deployment and further spikes in Covid cases in Europe and the US, and to some extent in Asia.
However, we believe a tipping point will be reached over the coming months, resulting in much stronger growth. Potential further upside surprises on the economic growth front could come from fiscal policy in Europe and the US. We are a bit more sceptical about sharp rises in either inflation expectations (given large excess capacity in the global economy) and bond yields (as central banks appear keen to intervene in bond markets to cap any increase in funding costs).
Subdued inflation and bond yields should not preclude the potential outperformance of value stocks in 2021 for three main reasons. First, the sharp underperformance of value equities in 2020 means that even if they were just to return to the trend seen since the global financial crisis of 2007/8, this would lead to a sharp outperformance in the coming months.
Second, while value stocks look expensive on traditional metrics relative to their own history, this could easily change if the fortunes of companies were to improve from the depressed earnings outlook that most analysts and investors hold. Meanwhile, relative to their growth counterparts, they are extremely cheap. Finally, value stocks, after underperforming growth for the past two decades, are unloved and under-owned.
Therefore, there are likely more potential buyers out there than sellers, should the situation improve. This situation reminds me of George Soros’ adage that the worse a situation becomes, the less it takes to turn it around and the bigger the upside. Of course, it is possible that we could be wrong and that value continues to underperform, especially if Covid is not eradicated, economic growth disappoints and bond yields go to fresh lows. This could continue to lead investors to favour growth stocks. Therefore, it would be prudent to maintain some exposure to growth style, even as we tilt towards value.
Since the March 2020 lows, value stocks have underperformed, but they still rose 50% to close the year largely unchanged. Therefore, adding more exposure to this still-unloved area of the market and diversifying away slightly from the area that has risen over 80% in the same period (and over 30% in 2020) probably makes a lot of sense.