The downtrend in value and uptrend in growth have been unstoppable over the last three years. And while in theory, ‘the trend is your friend’, in reality, it's only ‘until the bend at the end’.
And each trend hit a sharp bend in early September which has continued through October. One index that weighs value against growth has swung up by 11% from its early-September low.
While it's not in the DNA of value investors to get excited about a short-term move like this, we wanted to flag it and explore the theme further for you through the views of three leading Australian fund managers, because the implications are far-reaching if growth has peaked for now, and we are witnessing the long-overdue renaissance for value...
Changes in trend for value and growth?
They don’t call it a business 'cycle' for nothing
There have been several signs that a rotation was coming our way.
For starters, the market had recently spiked to new highs. Crucially the P/E ratio of the industrial ex-financials index had risen to the highest levels since at least the early 1990s, exceeding even the heights of the 1999 tech bubble.
Industrial ex-financials setting new long-term highs
Note in the chart that this is a pattern that repeats every decade or so; we had the dotcom boom (think Onetel, Davnet etc) in 1999/2000, following by the pre GFC bubble (REITs, Allco, CDOs etc) in 2008 and now we have another boom in tech and growth stocks. The same thing keeps repeating.
They don’t call it a 'business cycle' for nothing...
The P/E re-rate has been driven by CSL and the ubiquitous “WAAAX stocks”. Indeed, going into reporting season some of these tech stocks, like Afterpay, had large EPS downgrades, yet their share prices continued to go up, which doesn’t make any sense. We thought some sort of correction was overdue.
In the US insider selling recently reached 20-year highs. In addition, the percentage of IPOS that have negative earnings is at twenty-year highs.
This looks, sounds and smells like a growth/momentum market just primed to roll over and just waiting for a turning point.
September was a reminder about how quickly things change, and often with little or no warning. In a sense, it’s a microcosm of the larger rotation that will eventually strike as the cycle rolls over.
Every time the markets (whether in the US or here) have panicked in the last few years the same thing happens: value does well while growth and momentum gets crushed.
At the end of the cycle, it is the same, except it goes on for longer, and without reprieve until the market fully resets.
Three reasons value could make a comeback
In almost 20 years of Australian equity market data seen in the chart below, we have observed five distinct growth and value cycles as defined by MSCI Australia. The most recent of these market cycles started around January 2017, a period where ‘growth’ companies have outperformed ‘value’ stocks by approximately 17% p.a. as indicated by the upward sloping trendline.
Data source: MSCI Australia
The outperformance of growth vs value stocks has led to some market commentators to ask the question, ‘Is value investing dead?’
However, in September 2019 we saw Australian ‘value’ stocks stage a short and sharp recovery, outperforming growth by approximately 4%.
And whilst one month’s data point is not a trend, it is a timely reminder that markets move in cycles. And this market cycle is as likely to come to an end as previous growth cycles have done in the past.
So, is this the turning point for value stocks? Three reasons why value stocks could make a comeback include:
Have interest rates nearly bottomed?
In the context of the Australian market, the cash rate at the time of writing sits at 1.00%, and market consensus forecasts have this lowering to 0.50% within the next 12 months. The effectiveness of the RBA dropping rates lower than this rapidly diminishes, as banks would find it hard to pass on the full impact to borrowers.
Thus, at that point, we would likely see alternative monetary policy, such as quantitative easing (QE) kick in. QE would likely provide a broad-based economic uplift (good for value stocks), rather than the asset price inflation of lowering the cash rate that we have seen so far.
Does an Australian fiscal stimulus emerge?
Whilst the political promise of producing a fiscal surplus in May 2020 continues to be the agenda of the current government, beyond this the spending may begin.
Whether the spending is on infrastructure, tax reductions/refunds, or other initiatives – government is likely to spend on broad-reaching policies that improve the confidence and hip-pockets of the Australian voting public. A good environment for value stocks.
Is the trade war resolved?
The biggest impact we are seeing from the trade war between the US and China is the impact on business confidence. When a company’s end markets (and sometimes their cost base) are impacted by tariffs, it has a direct impact on their earnings, and more importantly confidence in future investment.
Not to mention the constant headlines drumming up fear and uncertainty in consumers and investors alike. Any resolution may see a pick-up in business and consumer confidence – any subsequent spending could end up on the revenue line of value stocks (think retailers, builders and the like).
Read our full thesis
In a recent wire - Growth V Value - Is this the turning point? - we extended our discussion, including the arguments supporting the opposing view, and our overarching thesis on the value versus growth debate and how we navigate it.
Businesslike investments will win out over the long run
Alex Shevelev, Forager Funds
Legendary investor Ben Graham put it well when he said:
“Investment is most intelligent when it is most businesslike.”
However, for the time being, there is no emerging epidemic of businesslike thinking on the ASX. Intelligent investment, whether by value or growth investors, will consider growth in future cash flows as one important component of any business valuation. Plenty of investors have done well ‘paying up’ for underappreciated growth prospects. They are often being sensible and businesslike doing so.
Growth has outperformed value on the ASX. Last financial year the difference in performance was 4%. So far this year the two indices are running roughly on par. But compared to the stellar returns from the highly speculative end of the market, the difference between value and growth performance seems paltry.
The speculative pockets of the market have been thriving. We recently looked at ten stocks with less than $50m of revenue but market capitalisations of more than $500m. Despite being up an average of almost 200% last financial year, many of these stocks have continued to skyrocket since June.
While I’m sure investors in such high-flying stocks might convince themselves they are making an assessment of a business’s long term cash-generating capacity, these are not businesslike investments.
Momentum, recent revenue growth and news flow take precedence over a sober assessment of long-term potential.
Businesslike investments will win out over the long run. And when they do, speculative bubbles will do what speculative bubbles usually do.
Deflate.
In summary
As Vince Pezzullo pointed out, the foundations of a reversal are in place: valuations are stretched beyond logic and reason, there is record insider selling, and we are seeing signs the cycle is topping.
While sometimes trends change overnight for no discernible reason, a sustained switch from growth to value may need fundamental drivers to support it though, and James Miller pointed out some potential drivers: QE, fiscal stimulus and the end of the trade war, all of which are quite conceivable.
Alex Shevelev reinforced the dogmatic view of the value investor which has served them well for the last eight decades: 'Businesslike investments will win out over the long run'.
This trend is just eight weeks old, and of course, one swallow does not make a summer.. but seeing a swallow suggests you should probably keep an eye out for other swallows - and maybe even get your boardies out of storage too...
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