Equity Fund

Value vs Growth: Where to Next?

By 23 March 2019May 11th, 2021No Comments

History of Value vs Growth

As we wrote about in our June 2018 quarterly report, research shows that value investing outperforms growth strategies by some margin over the very long term (Figure 1). This is what one would normally expect; if you consistently buy low and sell high, you should be rewarded over the long term. However, since the GFC there has been a remarkable reversal of this trend to the extent that it has been the greatest divergence ever, even more than the Dotcom Boom. Many value fund managers have closed and there have been numerous articles written about the death of the value strategy.

Figure 1: Differing Investing Styles – History – WWM Internal Research

Figure 2: Differing Investing Styles – Last 10 Years – WWM Internal Research

A question we often get asked and one that we see many people speculating on is when (or will) this trend ever reverse? The market typically goes through cycles where one style will beat the other for periods of time but the length and divergence over the 12 years has been so extraordinary that many have become convinced that “this time is different”.

 

Effect of Interest Rates

One factor that we feel that has been consistently overlooked is the effect of interest rates on the cycle over the last few years. Governments and central banks have pumped in an enormous amount of liquidity to keep the system afloat and themselves in power with little care or plans for ever repaying this money. The Federal Reserve Rate over the last 12 years has gone from around 5% to effectively zero today. Even though there was a brief tightening cycle in 2018, the amount of liquidity being pumped in by governments and central banks was, and still is extraordinary and created some relatively strange phenomenon, including but not limited to, more than $13 trillion worth of negative yielding debt globally. Additionally, the Federal Reserve in the United States is now buying listed securities just to pump up the market, and in Australia the Reserve Bank is trying control the yield curve.

The worth of a company is the value of all future dividends discounted to today. What discount rate a person wishes to choose is up to them, and this can have a big effect on what they deem a company to be worth, but this rate is commonly referenced to 10-year government bond rates. As a general rule, value stocks have a greater proportion of their worth based on profits or dividends in the near term while growth stocks have a greater proportion of their value based on profits or dividends that are in later years.

Compounding means that $100 in 1 years’ time is worth more than $100 in 5 years’ time, and so on. When interest rates are decreasing the compounding effect diminishes, this can be more simply explained using numbers: If we use a discount rate of 5%, $100 in 1 years’ time is worth $95.24 today while $100 in 5 years’ time is worth $78.35, so a difference of $16.89. If we use a discount rate of 1% then the numbers are $99.01 and $95.15, a much smaller difference of only $3.86.

In practice this has had a huge effect on the share market, and we think has driven a lot of the outperformance in growth stocks. This can be shown in the Table 1 below. Say there are 2 hypothetical companies: Company 1 will pay dividends of $100 from years 1 to 5 while Company 2 is going to pay dividends of $100 from years 6 to 10. In the first scenario we discount the dividends by 5% and in the second scenario we discount the dividends by 1%. Note these can be thought of as a proxy for a value and growth companies with Company 1 being a value stock and Company 2 being a growth stock.

As seen above, the value of Company 1 went up by 12% while Company 2 went up by 36% when we changed the discount rates to mirror what has happened over the last 12 years. This is effectively what has happened in the share market over the last decade, growth stocks have benefited by discount rate decreases to a much greater degree, driving massive outperformance. Many value fund managers having lived through the lessons of the past tend to apply higher discount rates as a measure of safety. We would suggest that the current risk premium for equities is too low, cycles tend to mean revert and as such, it seems likely that rates should go up again. So now we must ask where do we go from here?

As we have suggested we believe that discount rates will increase again. Either central banks will keep printing money, which will eventually drive inflation and therefore increase interest rates, or they will pull back their easing and the scarcity of money will increase, which will drive interest rates higher. It seems like the only way forward for rates is up! However, some people suggest that the world may be going in the direction of Japan where interest and discount rates remain low for a very long period of time. We think this is unlikely as the developed world does not have a shrinking population akin to Japan, but we admit that this is a possibility, so let us not discount it completely.

The Power of Dividends

If discount rates do go up, then value stocks will do much better as investors will once again place more value on hard assets and near-term earnings. Value investors have been using higher discount rates compared to the prevailing market and should thrive in this environment. However, if the opposite is true and we go in the direction of Japan, then it is likely that dividends will become more important as there is limited room for prices to grow. From 1930 to 2019, dividend income typically represented 42% of the return of the S&P500 with 58% coming from share price appreciation. However, dividends play a much more important role if they are reinvested due to the effect of compounding, from 1970 to 2019, 78% of the total return of the S&P500 index can be attributed to reinvested dividends with only 22% to price appreciation. Looking at the US market today, the MSCI Value Index is on a dividend yield of over 3.08% while the MSCI Growth Index is trading on a dividend yield of 0.71%. Even if we do go in the direction of Japan, it looks like value stocks will still outperform.

 

Where to from here?

One of the reasons that analysts and fund managers alike are trying to justify sky-high prices for certain growth stocks is that they believe these companies are asset light and therefore many predict very high returns on equity in their forecasts with which they can pay a lot of dividends in the future.

We don’t disagree with this, some (but importantly not all) tech and other growth stocks are very good quality businesses that can grow and are able to generate very high returns on capital with strong brand power. But with excess returns on equity comes increased competition and disruption. A classic example is the “Nifty Fifty” of the 1970s where the market determined these were solid “blue-chip” buy and hold stocks. Subsequently they underperformed for many years and many became defunct. At the time, much like a lot of the so called “blue-chips” of today, their margins and return on invested capital were above the norm.

In capitalist markets, enterprising people see excess profits being generated and start to compete and come up with substitute products. Typically in the past, incumbents needed to keep investing to stay ahead of the curve and this in itself reduced their excess returns on equity and the payment of healthy dividends back to shareholders. We think it is likely the same will happen again, and if so, investors in these growth companies may ultimately lose a significant proportion of their capital invested. This is a key reason as to why value stocks tend to outperform over very long cycles. They are often asset rich, operate in established markets, don’t have excess returns on capital to encourage fresh entrants, they don’t have to spend such a large proportion of their profits on R&D to stay ahead of the competition and most of their profits can be paid out as dividends which will then start compounding for the investor over the long term.

In conclusion, the last 12 years has been tough for value-oriented fund managers as they have been swimming against a strong tide which has not been in their favour. However, this looks set to change regardless of where the world is heading. There are always cycles that will benefit one party over the other and we think that it is now the time for value managers to rise up and swim with the tide once again.