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Value is in the Spotlight, but Don’t Give Up on Growth

Brian BandsmaBy Brian Bandsma
Portfolio Manager and Senior Research Analyst
Vontobel Asset Management

Strong momentum across many markets has increased investors’ concerns about inflated valuations. As the “growth-at-any-price” trade seems to be fading, many believe a rotation into value may continue to outperform the broader market. Across the globe, equity markets appear to offer a lot of bargains with banks, utilities, telecommunications companies, materials, and energy producers trading at single-digit multiples and with dividend yields of 4% to 7%.

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Although the spotlight has shifted to value, there are ample reasons to hold onto growth. Here are a few things to consider: 

Markets Are More Efficient Today

Market data have become more accessible over time, leaving fewer undiscovered opportunities. Quantitative funds using algorithms to automate the process of rapidly scouring press releases, company-reported numbers—and even social media posts—make simplistic strategies, such as buying stocks based on quantitative measures like low price-to-earnings (P/E) ratios or free cash flow yield, less likely to outperform.

Many Cheap Stocks Are Cheap for Good Reason

While value stocks may provide downside protection due to their low valuation and high dividend payout, outside of any potential short-term rerating, these stocks are priced low because the future cash flows for these companies are not expected to grow and may even deteriorate. In other words, sometimes a low P/E stock is just what it looks like: a low P/E stock.

Few Businesses Can Escape the Corrosive Impact of Inflation

Over the long term, equity markets have historically offered returns around 10%—or closer to 7% adjusting for inflation. A stock with no earnings growth can only generate a return equal to its dividend. Since even the cheaper value names have yields below the long-term expected rate of return, on face value an investor would be losing out by buying and holding on to these stocks. In today’s environment, it is important to examine the impact of inflation on a business, especially as central banks risk overshooting the monetary expansion used to compensate for the demand shock resulting from COVID lockdowns.

Growth Stocks May Not Be as Expensive as They Appear

Equity valuations have a loose correlation to bond yields, whereby P/E ratios will increase to reflect the lower relative returns from bonds. With very low yields around the world, it is reasonable for equity markets to respond to this reality. Growth has become more highly prized, and multiples have risen. Unless yields start to move up meaningfully, growth stocks may not be as expensive as they appear. A stock trading at 50 times P/E today is not the same as a stock trading at 50 times P/E 20 years ago, because the expected future rate of return is relative to all other possible opportunities at the time. The same could be said of so-called value stocks. The reason valuations for value stocks did not go up to the same degree as growth stocks is more likely explained by a general expectation of a greater dispersion in the cash flow growth among businesses.

Structurally Disruptive Growth Stocks Have Been More Resilient

Historically, value stocks have been expected to provide downside protection in the event of a broader market sell-off, such as the Global Financial Crisis of 2008-2009 or the COVID sell-off in March 2020. In fact, very little proved to be defensive for both of these historic events. More recently, higher P/E growth stocks seem to be the more resilient cohort in the face of a market downturn. This could be due to a consensus view that many companies currently exhibiting high growth are structurally disruptive and will continue to grow through market cycles via market share gains. Hence, in the face of redemptions, fund managers may be less willing to choose to sell these stocks.

In Conclusion

The recent rally in value stocks will also eventually fade. By definition, a cyclical rally has an expiration date. The challenges affecting the underlying businesses of low P/E stocks will not change after the economy gets back on its feet. Airlines, for example, will continue to fight for the extra passenger to improve load factors and dilute fixed costs, while taking risk on volatile fuel prices.

Real value, on the other hand, is more subtle. It is the outcome of real return on investment from a company’s free cash flow. This requires a deep understanding of the long-term performance of a company. We believe the best way to capture real value is to invest in predictable businesses. This is, in our view is also the best way to protect in the event of a downturn.

The commentary is the opinion of Vontobel Asset Management. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.


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