Growth vs value
What was first shall be last
IT HAS been a long wait. For more than six years, “value” investors (those who buy stocks that look cheap on selected valuation measures) have been outperforming, while their “growth” rivals (those who buy stocks on the expectation of rapid rises in profits) have lagged the market.
In part, this is revenge for the late 1990s when the growth school was in the ascendancy. Back then, it was almost a disadvantage for a company to make a profit. Investors were shunning “old economy” stocks (such as manufacturing or utility businesses) in favour of any dotcom business with a bright idea and a 26-year old chief executive. Value investors lost clients and, in many cases, their jobs.
All that changed in March 2000, and over the subsequent five or six years, the huge discrepancy in valuations disappeared. Instead of Nasdaq stocks trading on a price-earnings ratio of 100 (those that had earnings at all) and old economy stocks trading on a multiple of 10, the market converged on a narrow range of 15-20. As early as 2005, many were talking about a return to growth as being overdue.
This year, the growth camp has been rewarded. According to Lehman Brothers, as of October 15, high-growth stocks had beaten low-growth stocks by 10% since January 1. This trend could well continue. Although value stocks have tended to outperform over the long run, Lehman says that growth stocks have enjoyed phases of outperformance that have lasted for an average of 25 months.
Certainly, the Merrill Lynch survey of global fund managers shows that investors are anticipating a continuation of the trend. In July, a net 12% of managers thought that growth stocks would beat value over the next 12 months; by October, that proportion had risen to 31%.
Why the shift? Part of the reason must be the narrowing of valuation differentials; investors no longer have to pay so much of a premium to buy growth stocks. But the Merrill Lynch survey gives another clue: a net 44% of managers expect the general trend in corporate profits to deteriorate over the next 12 months, compared with just 12% in July.
The past five years has seen a remarkable surge in profits that has taken them to their highest level, as a proportion of American gross domestic product, in 40 years. In other words, it has not been difficult to find companies with fast-growing profits. But as the American economy slows under the impact of falling house prices, growth will become scarcer. As a consequence, growth companies will be valued more.
But where is growth to be found? Merrill also polled fund managers on this subject. Only three sectors fitted the bill: technology, materials and industrials. Technology should be no surprise; despite the bursting of the dotcom bubble, it is, in its nature, a growth industry. But the other two sectors used to be thought of as cyclical, and only to be bought when the world economy was in an upswing. Cyclical stocks traditionally traded at a discount to the market, rather than the premium usually paid for growth.
Clearly, investors have bought into the emerging-markets story, accepting that the fast-growing economies of India and China will result in rising demand for raw materials and some industrial goods (like machinery).
That squares with the view of fund managers who believe that, of all the regions, emerging markets has the most favourable profits outlook. And it lends weight to those who believe that 1999 could be replayed in 2008, with emerging markets taking the place of tech stocks. Growth stocks tend to be favoured when investors are at their most euphoric.