The ‘value versus growth’ debate is one that continues to polarise equity fund managers and investors alike. Indeed, many are even asking themselves whether value is dead after more than 10 years of strong and near continuous growth outperformance. The COVID-19 crisis this year has further fuelled this growth outperformance and the relative valuation gap between growth and value is now higher than the level seen in the dot.com boom 20 years ago.
An exaggerated valuation gap ushered the collapse in the dot.com boom in 2000 and a reversal in performance, with value equities leading the way for many years thereafter. While there appears to be little to suggest that the dot.com boom is repeating itself, could the relative performance of growth and value yet rhyme with the experience of 20 years ago?
There are of course a number of very good reasons why growth equities have been outperforming value equities. In parlance borrowed from fixed income investing, growth equities are longer duration assets as valuations are supported by earnings and shareholder returns that will occur further into the future. This means they benefit more than shorter duration assets as the discount rate falls (bond yields). Additionally, as yields fall, growth companies don’t suffer the same negative profit impact as the value area of the market that includes most of the banks and other financial companies. As such, growth equities should have outperformed as interest rates and the cost of capital have declined.
We have also arguably seen an acceleration in the structural change brought about by the internet and the digitalisation of our economies. This has supported growth companies, who are benefiting from faster growth and higher profitability, further supporting their outperformance.
However, nothing remains the same forever. History has given us many cycles between growth and value outperformance and while the explanations of these cycles have always been different, the rhyme of these cycles has remained with us. In all previous cycles, the outperformance of growth equities has expanded the relative valuation gap between growth and value equities and, ultimately, this has contributed to the reversal when the cycle has turned.
The cyclically adjusted price-to-earnings (CAPE) ratio is a good metric to use to judge overall market valuation and can help us understand the relative value between growth and value equities. CAPE is the current share price divided by the ten year average earnings adjusted for inflation. Here, we divide the CAPE for the MSCI World Growth index by the CAPE for the MSCI World Value index, to create a long-term relative valuation measure that can show us how expensive growth equities are compared to value equities.
The CAPE for growth equities is now above 50x and is at levels last seen at the end of the dot.com boom in 2001, while for value equities it remains below its 25-year average at 16x. This means the relative valuation measure now exceeds the levels experienced during the dot.com boom, challenging us to ask whether it has expanded too far once again.
Followers of CAPE will know that it is a poor short-term indicator, but has a good track record predicting longer-term equity returns. What that means in the current situation is that we can’t use it to predict when or at what level the growth outperformance will end, and indeed while we are still in the midst of a COVID-19 crisis it would be brave to do so.
However, taking a longer-term view, the extreme CAPE relative valuation we are witnessing would suggest much better expected returns for value equities, compared to growth, over the years ahead. Indeed, if growth equities continue to outperform in the short term, the relative valuation gap will continue to expand further increasing the strength of this longer-term view.
Investors have a difficult decision to make. Do they continue to lean their portfolios towards growth equities, especially the leaders such as Facebook, Amazon, Apple, Alphabet and Netflix, and expect to continue to benefit from their stronger growth and operational performance? Or do they recognise that relative valuation will play a role in the longer-term and re-position their portfolios away from more expensive areas of the market and towards areas that offer better value?
While it is difficult to predict the shape and timing of any post-COVID-19 economic recovery, it will happen at some point. At that stage, more cyclical companies that dominate the value areas of the market should show signs of life, and the higher interest rates may also start to work in favour of these value companies. Equally, politicians seem increasingly interested in challenging, taxing and potentially regulating the new business models that have benefited from the structural change and contributed so much to the outperformance of growth equities. Either of these events could trigger the next turning point in the growth versus value cycle. Investors should consider how they wish to position their portfolios to be ready for the next rhyme of this cycle.