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Why growth stocks are whacking value stocks

A vexed question in the markets right now is that growth stocks are going through the roof while value stocks are going nowhere. Investors are torn between chasing growth stories with nosebleed valuations or grinding it out with stocks exposed to a sick economy and uncertain outlook.

This contrast is illustrated in the following chart:

Source: L1 Capital and JP Morgan

The chart shows the difference over time in the price to earnings ratio of typical value and growth stocks. Putting it in simply, never have stocks with unique growth outlooks looked this expensive compared to the rest of the share market. The rubber band between value and growth valuation methods has been stretched even beyond the previous limits seen in the 2000 tech bubble. Naturally there is no agreement as to when it’ll snap back, but this chart does show that from time to time, and not that long ago, value has been more highly prized than growth.

Value stocks are normally assessed on sustainability of profit, cashflow, dividend and balance sheet strength. They are often cyclical, tending to falter during recessions but traditionally rebounding in economic recoveries.

Growth stocks tend to have a unique proposition around growing revenue projections, future profit potential and market share growth. In times of recession the few stocks with growth characteristics become highly sought after. In recessions, interest rates are low and growth stocks get an extra boost from investors applying a lower discount rate (i.e. a higher valuation) to future profits that are yet to materialise. In this COVID-19 recession, the extreme growth stories are mainly confined to technology stocks with the potential to capitalise on changed habits.

Value investors argue that over the long term, value style investing has delivered stronger returns than growth, perhaps because it’s boring, safer and more amenable to the positive compounding of wealth. Warren Buffet is the world’s most famous value investor and is known for buying predictable established players that pump out solid earnings. He doesn’t spend much time trying to predict future winners with new technologies, for him is about backing the strongest incumbent. He’s been noticeably quiet in the COVID-19 recession, hoarding cash until a recent $4bn splash into north American gas pipelines, very much an “old school” infrastructure value investment. He may be sticking with his style but in the last 3 months his investment conglomerate Berkshire Hathaway has fallen around 20% behind the S&P 500, the US share market index.

Growth investors are typically buying the next big thing. The story is exciting, but the risk is in picking the future industry winner (often only one contender can win, the rest will die), whether it executes its strategy and delivers on the promise.

In the Australian context, the extreme growth stocks most discussed are the WAAAX group – Wisetech, Afterpay, Appen, Altium and Xero. Between them these stocks have risen fivefold in the last 3 years. 3 years ago, the market was pricing them at $71 for each $1 of earnings. A price to earnings ratio of 71. Now the same stocks are commanding $168 for each $1 of current earnings. That’s a price to earnings ratio of 168. This ratio has more than doubled in 3 years for these stocks, despite the inevitable maturing of their underlying business models.

Source – Macquarie Private Wealth.

The notable outtake from this chart is that the “Market Cap”, the combined value of WAAAX stocks is up around 20% on its pre COVID value. Whereas the “Earnings”, the combined earnings of WAAAX stocks, is down over 25% on pre COVID estimates.

Every global share market has their growth darlings and currently they are mainly technology stories. In the US the heavy lifting has been done by the FAANG’s (Facebook, Apple, Amazon, Netflix and Alphabet – formally Google). Of these, the standout is probably Amazon, now valued at 110 times next year’s earnings. Only a few months ago it was valued at 55 next years’ earnings.

Tesla is another growth stock that has gone through the roof this year and as at last Friday, Bloomberg reported that Elon Musk, its CEO, became richer than Warren Buffet. And Tesla has just become the world’s most valuable car manufacturer, even though it is only in its first year of profitability and has a new car market share globally of under 1% (The market share leader and former most valuable car manufacturer is Toyota with around 13% market share, which is up from 10% in 2019. Toyota’s revenue, capital spending and research is ten times Tesla’s. Tesla has come a long way quickly though and does enjoy the leading market share globally in electric vehicles).

Why is this debate important? It’s important because trees don’t grow to the sky and in the past investment markets have always, eventually, reverted to the fundamentals. With recent gains concentrated in a small number of growth stocks, if or when the value growth equation “mean-reverts” to its long-term average, value stocks will become a safer bet and many growth stocks could fall heavily.

It’s hotly debated, but some experts believe that various growth bubbles appearing recently will burst when economic growth picks up, interest rates start to edge up again and the established players adopt new technologies.

For our part, with so many incredible anomalies having to be priced by the markets right now we think it’s never been more important to have diversification of investments, styles, approaches, sectors and asset classes. Our model portfolios do include growth stocks but plenty of value stocks too. We accept that provided a business is viable and well managed, there can be less downside and more upside with a boring cheap stock than an expensive one. It is tempting to chase the current growth stories, but the danger is switching too close to the top of the cycle.

There is evidence that recent buying support in global share markets has been largely driven by retail investors rather than institutional. Retail investors tend to favour growth stories over value and will need to remain patiently invested and support the necessary capital raisings to realise the promise of the market darlings.

The fund managers we select for your portfolios have experience across several styles and a process that will move between them, to some extent, as conditions change. No one has a crystal ball that can predict the next style rotation, but when it happens we need the flexibility to respond.

Disclosure Statement: This communication has been approved and issued by Sovereign Wealth Partners Pty Ltd ABN 18 607 071 367 Corporate Authorised Representative (No. 001233909) of Sovereign Capital Pty Ltd ABN 44 164 127 833, AFSL 456235.

General Advice Warning: Any advice included in this article and associated links is general in nature and does not take into account your objectives, financial situation or needs. If a product we recommend has a Product Disclosure Statement (PDS), you should read it before making a decision. Past performance is not a reliable indicator of future performance. We do not endorse any information from research providers that we provide to you, unless we specifically say so.

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