At the end of last year, it was difficult to find many cheerleaders for a growth approach. The narrative ran that a climate of higher interest rates and inflation was generally bad news for those companies with more of their value in the future. However, it is an inconvenient truth that growth has notably outpaced value since the start of the year.
For the year to date, the S&P 500 Value is up just 0.5%, while the S&P 500 Growth is up 6.1% (source. S&P Global, USD, to 24 March 2023). Within this, there have been some notable individual performances from growth companies. For example, Tesla is up 76% for the year to date, Meta is up 65%, while chip giant Nvidia is up 87% (to 24 March 2023). The top three sectors in the US market for the year to date are communication services, information technology and consumer discretionary.
What explains this apparent reversal? Certainly, changing expectations on interest rates have played a role. Inflation fears have calmed since the start of the year as commodity prices have slipped. However, interest rates remain high and while inflationary pressures may have moderated, they have not disappeared, as shown by the 10.4% CPI reading for the UK this month. As such, this doesn’t feel like the whole story.
Equally, the valuation differential between value and growth has not dissipated and remains wide by historic standards. The outperformance of value versus growth in 2022 was almost entirely a function of stronger earnings and interest rates, rather than a wholesale reappraisal of the individual merits of each factor. With this in mind, ‘value’ investing would appear to have a notable advantage on valuation as well.
The current strong outperformance by growth assets appears to have two elements: the first is that last year’s winners – notably energy and banking – are doing badly. Chris Rossbach, chief investment officer at J Stern & Co, says: “Everything that performed well last year is tanking this year.” He believes that while last year may have been a good year for the energy sector, it also showed the tremendous risk inherent in some of the fossil fuel companies: “There were bottlenecks and Putin saw that, but his bluff is about to be called. In the US gas prices are below pre-invasion highs and in Europe, they are falling significantly. Those sectors that look like inflation beneficiaries are being reassessed very sharply.”
Then there are the problems in the banking sector. Banks look cheap, and have drawn attention from value managers in recent weeks, which left them in difficulties when the recent crisis hit. Financials form around 20.5% of the S&P 500 Value index and only 3.6% of the S&P 500 Growth index.
However, there has also been some strength from growth companies themselves. Rossbach points out that areas such as digital advertising are coming back, while retail sales have continued to defy inflationary pressures. He adds: “Expectations were too high for some of these companies, but they have been addressed. We are still some way from peak digital penetration.” He says that the reopening of China is also helping support the consumer economy, particularly in Europe where demand for imported luxury goods is increasing. “We believe this trend has only just started.”
It helps that companies have reset on earnings with a disappointing round at the end of last year. This brought market expectations lower and should give these companies room to grow. Rob Rohn, portfolio manager, Sustainable Growth Advisers, believes that the broad brush penalising of longer duration growth companies left attractive opportunities in areas such as healthcare, technology, consumer discretionary and communications.
That said, Jake Moeller, senior investment consultant at Square Mile Investment, says the market is being more discerning in the type of growth it is willing to reward: “You need to be careful about the business model. Growth companies can be good if they have got a strong franchise, but some growth stocks were only supported by momentum – the ‘emperor’s new clothes’ phenomenon.” It is worth noting that there has not been the same rally in more speculative, pre-profitability companies.
Moeller believes that companies need capital discipline, sound dividend cover and strong free cashflow to impress investors and that can be found in both growth and value companies. “It is not enough to say that the business is going to grow. If a company misses earnings, it will be in trouble.” He says that the growth companies doing well are those that are plugged into big themes, such as renewable energy, the circular economy or cybersecurity.
The flip-flop between growth and value has been caught up in expectations around interest rates. As interest rate expectations fall, value is resurgent and vice versa. However, there is more nuance to this latest rally, which may suggest that investors are tentatively looking beyond monetary policy twists and turns to the merits of individual companies. However, there is a long way to go before investors can be said to have truly shaken off their interest rate obsession.