For value style investors, the past few years have been a true test of faith. Since the start of 2015, Australian growth managers have dominated, thanks to the low growth, low interest rate environment, which created a value trap for hopeful investors while boosting the present values of popular growth companies and sectors.
Then, just as it seemed the tide was starting to turn in value’s favour, the COVID-19 pandemic hit, throwing the market into disarray. While volatility has rocked growth managers, it has also seen yields move even lower and the prospects for growth, at least in the short term, head south. This mixed outlook has only added to the historic tension between the growth and value styles, with different managers taking different views on how value is measured and the impact that new technology and other disruptors will have on the market.
Value’s struggle in recent years is reflected in Lonsec’s peer group returns for Australian value and growth managers. As the chart below shows, Lonsec’s value peer group underperformed growth significantly over the past year to June, with the average manager returning -11.8% compared to the growth average of -2.7%. However, over the past three months value appears to have caught up, as both value and growth were swept up in the recovery.
Lonsec value versus growth peer group performance to 30 June 2020
Looking back over recent years, growth as an investment style has certainly outperformed. Over five years, growth funds have returned an average 7.0% p.a., compared to 3.7% for value. But how long can this run last? Dispersion between these two styles has not been this high since just before the tech wreck at the turn of the millennium, which saw value overtake growth as the predominant style. The chart below captures the US experience, but the situation is much the same in Australia. This begs the question: Are we due for another correction?
The short answer is, no one really knows. Writing off value at any point would be a bad idea, given its long-term track record. There are numerous studies suggesting that over the long-term the value approach outperforms growth, with well-known investors and academics such as Ben Graham and Warren Buffett being notable proponents of value style investing. The idea of mean-reversion and values moving in line with fundamentals over time appear to be tried and tested concepts.
So why has the value style investing lagged growth over the past decade? Firstly, the low interest rate environment which followed global financial crisis in 2008 has benefited growth companies. Growth companies that are expected to grow their free cashflow in the future are typically more sensitive to interest rates, in a similar way to a long duration bond. With interest rates at low levels and continuing to fall in some markets, growth stocks have continued to perform well.
Secondly, global equity markets, including the US, have been fuelled by the strength of high growth sectors such as the technology sector with the so called FAANG stocks (Facebook, Apple, Amazon, Netflix and Alphabet), which have until recently driven a significant portion of US market returns. Australia is not to be outdone with its own version of growth darlings: the so-called WAAX stocks (Wisetech Global, Afterpay, Altium, Appen and Xero).
What could be the catalyst to spark a value comeback? At least in the short term, it is difficult to see interest rates rising any time soon, while growth is expected to be impacted by the Covid-19 pandemic. However, there is an argument that, instead of value underperforming, growth has been outperforming. In other words, investors have been paying too much for growth.
In a market characterised by a scarcity of growth opportunities, investors may be tempted to adopt a ‘growth at any price’ (GAAP) mentality, leading them to pay high multiples for shares the market believes can deliver growth. There is a risk that a GAAP-like approach can lead to herding into a small group of shares (like the FAANG shares mentioned above). Investors should avoid grouping shares together based on labels, and instead focus on the underlying business model of each share in order to understand the risks and opportunities that each present.
Given the liquidity that has been pumped into markets, there is a chance that the market will begin to sense a danger zone in terms of valuations. If so, we could see a reversion in the growth trend and possibly a comeback from value stocks. Exactly how this would play out and over what time period is unclear. Trying to time these kinds of style factors is often a futile game. For investors looking to achieve diversification, it is important to maintain exposure to both styles in order to spread the risk.
The real task for investors seeking diversified portfolios is to identify high-quality managers across both investment styles and understand how these different exposures can be combined to manage risk. In times like these, where trends and counter trends are competing for victory, unless you have a crystal ball it is impossible to know which style will outperform over which period. Expect the value versus growth debate to keep intensifying as we move through the pandemic, but remember no one can know for sure what the market will bring us, especially in 2020.
Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2020 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited.