Have you seen how well Growth stocks did since January 2017?
It has appeared that the traditionally comparable medium-run performance of Growth and Value stocks has clearly tilted in favor of the Growth stocks in the most recent months. I will use public data on S&P500 Growth and Value indices, available on the Standard and Poor's index website to show this change.
Let’s put it straight: the debate among investors to know which is better between Growth or Value stock has no real good answer. Indeed, different investors have different needs and time horizons that will make one investment more adequate, and diversification commands that a wise investor considers the whole investable universe (or at least both Value and Growth stocks) to build an efficient portfolio. That being said, clear trends still emerge when we observe the risks and returns on Growth and Value stocks.
If you don’t clearly remember what Growth and Value stocks are, now is the right moment for you have a look to that short article that will remind you the essentials on Growth and Value stocks.
Value stocks are usually said to be better performing on the long run
Eminent investors have claimed to have built significant wealth while applying an investment strategy based on Value stocks against Growth stocks. Warren Buffet is one of these well-known Value stocks gurus.
A common idea among investors is that on the long run, Value stocks tend to outperform Growth stocks. The rationale is that Growth stocks are usually over-valued because (among other reasons) of a behavioral bias: they benefit from more media coverage than the slower growing stocks and become trending stocks. Because everyone seems interested in these stocks, they appear safer than they really are, a “herding” phenomenon appears, and unexperienced stock pickers will consider it a good bet without doing sufficient research on the company fundamentals or understanding the underlying turnout growth expectations. Mini-bubbles are forming around this kind of stocks and can lead to big losses in adverse situations. This is of course a simplified view of the risks posed by Growth stocks.
The performance advantages of the Value stocks are not only on behavioral grounds. Another very important feature of Value stocks is that they provide an above average dividend yield. This is an important feature when the investor has regular liquidity needs, and its taxation framework doesn’t advantage too much capital gain over dividends. In the current low rate environment for example, safe Value stocks have been more often than before considered a viable alternative to some corporate bonds, as dividends are expected to be regular and stable just like coupons would be.
S&P500 Growth stocks have had better results on average since early 2017
And yet in spite of the advantages Value stocks seem to have, we clearly observe that they have been undersold since early 2017. Let us focus now on the latest performance results.
It looks like since March 2017, a significant gap has been building up between Growth and Value stocks in terms of total return, when we look at the S&P500 Value and Growth indices.
Yet, over the last 10 years, the gap between Growth and Value stocks in terms of Sharpe ratio has never been that high. If we trust the Sharpe ratio, it would have been much more interesting to hold Growth stocks since April 2017 than Value stocks. Such a gap is larger than anything that has happened in the 10 previous years.
Why do we observe a gap between Growth and Value stock performance?
As we observe this trend, the obvious next question is why? And to this question, no unique answer can be found but instead a bunch of answers can be compounded to observe this impact.
Let us first give a look at the components of the Growth index and Value index. We observe that the S&P500 Growth index is primarily made of Tech companies like Alphabet (formerly Google), Microsoft, Nvidia, Apple, Facebook, while the Value index is essentially constituted of Financials (JP Morgan, Wells Fargo, Bank of America, Citigroup), Energy companies (Exxon Mobile, Chevron) and Industrial companies. This difference means that these groups are exposed to extremely different trends and business environment that largely explains the underperformance of the Value index since early 2017.
We can isolate specific trends for each of these business sectors that can partly explain the observed market move.
The Value group is mostly made of Financial and Energy companies.
The beginning of 2017 hasn’t been a great period for Industrial, Energy and Financials in the US.
- Energy companies have had a rough first semester in 2017 because of the low energy price. The WTI has been stuck well below the 60 USD mark since the beginning of 2017. The low price is largely linked to the growth of the US production.
Above is the price history of the WTI (West Texas Intermediate) first future generic issue over the last 5 years. This is a screenshot from Bloomberg.com, link in the sources below.
- Financials in the US have been largely impacted by :
- Political risks and uncertainty raised by the election of Donald Trump. Investors initially sounded very optimistic with this openly business friendly president. The many scandals that followed and his inability to implement some elements of his program so far (replacement of Obamacare, tight immigration restriction) have worn-out the investors’ confidence in his ability to govern.
- Interest rate risks: The Fed has increasingly strengthened its hawkish stance, leading to a steady increase in interest rates. This is weighing on the bank’s loan inventory value, their willingness to lend and borrow, their refinancing ability and the activity of the capital markets…
Above is a graph taken from global-rates.com showing the evolution of the USD Libor 3m over several periods.
The Growth group is majorly composed of Tech companies
On the contrary for Tech stocks, early 2017 has been a good period. There are many potential explanations to this trend.
- Tech stocks are seeing the effect of a bubble. Growth expectations implied by stocks prices are defying gravity. Tesla for example accomplishes the feat of being the most valuable (Share price x Outstanding shares) in the US, ahead of General Motor and Ford! And it does this while it sold in Q1 2017 not 10 but 20 times LESS cars than GM! This is just an example of the many bubbles currently happening in the Tech sector:
- Smart cars and drones: all leading Tech companies seem to have announced at some point they were working on the motorized prototype: Amazon and it delivery drones, Google, Apple and their smart car…
- Cryptocurrencies, block chain technologies, deep learning and AI technologies (with the first victory of artificial intelligence (Alphabet’s Alpha Go) versus a human in a go competition.
- And many more technological breakthrough that I won’t detail as it is not the scope of this article obviously.
- Growth stocks in general are usually more sensitive to economic cycles than Value stocks. Stocks that are considered to have some growth potential are usually benefitting more from periods of good investor confidence and economic growth like we are seen since the beginning of 2017. These stocks are potentially riskier than Value stocks because their price is high already, but due to the clement economic environment investors are more optimistic and their prices continue to increase.