Great Rotation to Value Keeps Rolling

Growth and value stocks have been fighting for centre stage all through 2021, but many observers see value taking over.

“Growth has been the dominant style for the U.S. equity market for pretty much all of the 2010s,” recalls Craig Basinger, chief investment officer at Richardson Wealth. “Based on the S&P 500 style indices, he continues, growth beat value in every year from 2007-2020 with the exception of 2012 and 2016.” The year 2020 was a triumph when growth stocks rose by 32% while value stocks dipped by 1.4%.

But the tide turned at the end of 2020. Value started to outperform, Basinger notes, thanks to favourable winds: a substantial valuation discount, the re-opening of the economy set to benefit the value style, rising yields and rising inflation.

Delayed Shift Courtesy of Delta

But the brakes screeched on a 'great value rotation' in early summer and growth reared its enthusiastic head again. The delta variant was rising and dampening expectations of renewed economic growth, giving an advantage to growth stocks.

There is a paradox here: as growth perspectives diminish, growth stocks surge. But the paradox is only apparent. “Growth stocks, especially technology, greatly benefited from lockdowns”, says David Sekera, chief market strategist at Morningstar.

“Investors embraced the ‘growth scare’ story and the ‘lower for longer’ view on interest rates. The Federal Reserve’s restatements of patience around inflation risk rewarded that narrative,” recalls Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management in a recent note. Other factors, she adds, fueled the growth scare, notably supply-chain issues and China’s recent regulatory crackdowns.

Why value would outperform hinges on the fact that renewed growth sets up a larger platform for earnings. “Better economic growth means more companies are growing earnings, Basinger points out; this reduces the scarcity of growth that sometimes occurs and favours growth stocks.”

Jitters Subsiding

The prevailing anxiety will be short-lived, believe all three analysts. “We still see the U.S. economy normalizing and reopening this year, states Sekera. There might be some limited instances of masking and social distancing, he continues, but we don’t see any lockdown on the scope of what we saw last year.” Shalett agrees: “We expect global economic growth to reaccelerate and bring about another round of sector rotation that could spur value and cyclical stock outperformance.”

Stock valuations certainly exhibit a favourable value tilt. “There is no denying the valuation gap remains elevated to the extreme between value and growth, pointed out Basinger in a June 28 note. At that moment, growth was trading at 27.3 times forward earnings, value, at 17.1 times. Such a 10-point valuation spread between the two investment styles, he continues, is “in the 98^th percentile extreme based on the past twenty years, meaning that growth is very expensive compared to value.”

Don’t Lose Money

Value might have been out of favour for a decade, but its fundamental principles endure, considers Tim McElvaine, portfolio manager of the McElvaine Value Fund, who espouses Nassim Nicholas Taleb’s concept of antifragility. “We should focus on fragility over risk,” he thinks.

The key question is not whether a stock is risky or safe, but whether it is fragile or solid. “Growth proponents favour the upside of stocks, McElvaine notes. A value proponent asks: is my downside protected. If you don’t lose money, after that all options are good.”

But he pushes the fragility/solidity framing of risk further. Not only does he seek out stocks that show strength in adversity, but stocks that will get stronger in adversity. “A company needs to have the financial capacity to survive over a few years of hardship, and to even thrive.”

Discounts in China Debt Worries

That very often prompts him to be a contrarian, for example with his purchase of CK Hutchison Holdings (CKHUY), the conglomerate of famed Hong Kong investor Li Ka-shing, at a time when everybody is running away from Asian stocks. “Because of the anguish over China, investors have sold the stock for half of what it’s worth, yet that company is rock solid with a strong balance sheet, a 5% dividend yield and a dominant business in most sectors in which it operates.”

As a portfolio, McElvaine’s value fund delivered 6.6%, which appears timid in comparison to a growth fund such as Dynamic’s Power Global Growth’s F-series 10-year return of 19.7%. However, if tail winds favour value again, his fund could bring in hefty returns, as it did in 2013 and 2017 with growth spurts of 19.1 and 25% respectively.

The question, of course, is: will value outperform? McElvaine gives a typical value investor’s answer: “In don’t really know. I’m very suspicious of investing on predictions of the future. Still I hope forecasters are right; it would be good to have a bit of tailwind for a while.”

For Basinger, Sekera and Shalett, the crystal ball is clear. “Add the yield outlook to the valuation spread, asserts Basinger, improving economic growth, improving earnings growth, inflation outlook, and all these factors favour value over growth. We believe this rotation, despite a short-term setback, is just getting started.”