“Skate to where the puck is going, not where it has been .” – Wayne Gretzky
It is in our human nature to have dualistic viewpoints, so investors often tend to herd into market segments based on what is doing best, despite the common small print warnings that past performance has nothing to do with future performance.
This tendency can be seen in various fund flows, and a great recent example are those at New York-based technology-focused Ark Investment Management LLC. Its assets have grown to more than US$50 billion today, from a little over US$3.5 billion early last year.
In this regard, the battle between value and growth has been an interesting one to watch, especially given what has been unfolding more recently.
For those not familiar with the categories, value stocks are those that trade at a discount to the broader market, possibly due to their sector being out of favour, either because they are facing potential disruption or simply because their revenue growth is not as attractive as other segments. They also tend to have slower, steadier and more predictable revenue growth backstopped by a higher level of profitability. Some have protective moats, while those that don’t may face disruption risk if they are not able to adapt to an emerging technological threat.
Examples include Berkshire Hathaway Inc. and JPMorgan Chase & Co. in the financials sector, Johnson & Johnson in health care and even Exxon Mobil Corp. in energy.
Growth stocks are those that trade based on their future potential, so they will command a premium multiple as long as they continue to meet revenue expectations. Technology stocks tend to dominate the category, especially those deploying the loss-leader model of burning through cash in order to obtain users and rapidly grow their own ecosystems.
Everything will remain fine as long as those ecosystems continue to expand at the expected pace and, ultimately, are converted into profitable ones, not unlike what companies such as Amazon.com Inc. and Apple Inc. have done.
Given the digitization of the global economy, which was fuelled by inexpensive capital following the 2008 correction and accelerated during the COVID-19 lockdowns, growth stocks have outperformed value and still trade at a large multiple premium, meaning this is expected to continue in the years to come.
Specifically, over the past 10 years, as of April 30, the Russell 1000 Value Index has delivered an annual return of 11.13 per cent compared to the whopping 17.12 per cent by the Russell 1000 Growth Index. Over the past five years, this gap has exploded even wider, with an annual gain of 12.15 per cent for value versus 22.88 per cent for growth. As a result, value is trading at 25 times earnings whereas growth is at 43 times.
However, this gap is starting to narrow because of increased expectations for inflation and higher interest rates, both of which would be extremely punitive to a growth-oriented technology sector that is heavily dependent on inexpensive and readily available capital to spur growth. Meanwhile, value components, such as the underinvested energy sector, are only just beginning to shine and the gap is starting to narrow.
The Russell 1000 Value Index, as of April 30, is up 11.26 per cent on the year, compared to 0.94 per cent for the Russell 1000 Growth. That said, we are not alone in thinking that there may be plenty of room for this trend to continue.
Historically, according to Credit Suisse research, the Russell 1000 Growth Index trades at a multiple point premium of 5.6 times that of the value index, and it currently trades at 10.3 times. Each multiple point of narrowing represents excess returns of four to five per cent for the value index. Value, with the ongoing economic restart due to mass vaccine deployment, is now expected to deliver 10.4 per cent faster EPS growth this year.
We are not advocating a binary approach or a complete shift from away from growth to value, but perhaps some good old-fashioned rebalancing wouldn’t hurt by taking profit from the tech sector and skating to where the puck appears to be heading, that is, those value segments offering superior earnings visibility.
Martin Pelletier, CFA, is a portfolio manager at Wellington-Altus Private Counsel Inc. (formerly TriVest Wealth Counsel Ltd.), a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax and estate planning.