The Growth Tide Rolls On – For How Long?
Posted on November 16, 2020
Historical returns in the market have validated that value stocks outperform growth stocks over long periods of time. Yet, there have been many periods over which leadership has rotated, persisted for a while, and challenged the patience of investors with exposure to value stocks. In the past 14 years, for example, growth stocks have outperformed value stocks by 6.3% annually. This is the longest and perhaps largest divergence between the two equity styles seen in at least 40 years.
As the period of divergence from normal patterns lengthens, investors and researchers look for rationales, for catalysts that would drive stocks back to their historical trends, or for clues that the shift may be permanent. During the late 1990s, many were asking whether technological innovations could explain the divergence. Sound familiar?
As you may recall, growth stocks outperformed value from 1994 to 2000, averaging 10.5% in excess compounded annual returns. Not only was performance well outside of the norm then, so too were valuations. A study in the Financial Analysts Journal in the summer of 2000, just after tech stocks peaked, attempted to evaluate the various rationales. The study revealed that, rather than positive surprises in growth or innovation driving higher stock price multiples, it seemed that the most plausible explanation was behavioral. Actual growth in sales and consensus forecasts were within normal historical ranges, yet price-to-sales ratios doubled in just two years leading up to the rotation. Other measures of relative valuation likewise confirmed prices seemed disconnected from fundamentals.
Currently, growth stocks are trading at 4.6x sales (more than twice their historical average and persistently above the 15-year average for the last five years). At the same time, the 5-year average sales growth rate of these stocks has declined from 9.3% to 7.4%. Consensus estimates are that sales growth will remain near 7.4%. So, if the outlook for growth doesn’t justify the high multiples, what could?
The most cited explanation has to do with sector exposure of the indices. The growth index is dominated by large weightings to technology and healthcare, both sectors that seem poised to benefit from secular trends that have been accelerated by the pandemic. Conversely, the largest sector weight in the value index is financials, which have faced headwinds since 2008 from declining interest rates and increased regulation.
While sector weightings seem a reasonable explanation, we can’t help but wonder whether investor sentiment has gotten carried away again, a situation that in the past has led to significant reversals. Positive information and a hopeful outlook can certainly drive up prices, leading to positive momentum and creating a feedback loop. This time may be just another example.
All of this has meaningful impact on portfolio strategies and short-term performance. While it may be tempting to shift exposures to capture the momentum, there is no way of knowing when the tide will roll out. Rather than make directional bets, we adhere to our disciplined approach to equity exposure. We firmly believe there is a place in the portfolio for both growth and value styles, that client circumstances matter in this equation, and that trying to time the exposure tends to produce inferior results. Finally, valuations tend to be good predictors of forward returns, with high valuations suggesting lower expected future returns for growth stocks. Therefore, those able to exercise patience with value-oriented investments should eventually stand to benefit.
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