Value versus growth: expect volatility more than a smooth transition of leadership

Trevor Noren, Director Thematic Strategy
2022-09-30
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Doubling down on fundamentals is likely the key path to outperformance 

In a recent internal note, Global Derivatives Director Gordy Lawrence encapsulated the magnitude of the rotation from growth to value in January:

“Using the Bloomberg Pure Value and Pure Growth factor indices as proxies, we note that value’s return for the week (+2.61%) is in the 99.8th percentile of observations since 2000 (the seventh best out of 5,500 rolling five-day return periods), while growth’s return over the period (-1.45%) has only been worse one other time since 2000. The net result was that the performance spread between value and growth (+4.06%) was the second largest since 2000 (the five-day period ending 29 November 2000).”

Figure 1
value versus growth expect volatility fig1

Throughout growth’s more than decade-long run of dominance, market prognosticators have often called for a reversal of value’s fortunes. Pockets of growth excess have been apparent, from eye-watering valuations for unprofitable tech companies to SPAC euphoria to record retail participation (and leverage) in markets. Meanwhile, value stocks have been historically cheap. As Chris Grohe, Associate Director at QIG Equity Research, calculated recently, the cheapness of US value stocks relative to growth was at its 98th percentile as of November 2021. In Europe, that number was the 92nd percentile. In Asia (ex-Japan), it was the 91st percentile.

Does the violence of January’s rotation suggest regime change is upon us and a sustained reversal in the performance of growth versus value is underway? In recent days, this question inspired one of the richest debates across Wellington’s breadth of expertise in memory. A few of the key questions we considered: will inflation moderate or continue to exceed expectations? Will central banks miscalculate the speed of tightening? Do we need to reassess our valuation metrics — temporarily or permanently — given modern market structures?

The debate was a powerful reminder of why we have no CIO. Consensus should not be the goal when so many unknowns remain. Our bottom-up debate leverages expertise across our investment platform on an equal footing. And from that debate emerges an opportunity set —actionable ideas undeterred by a single, top-down perspective. 

As we have often written, today’s macro uncertainty is likely to result in elevated market volatility. January was a glimpse of indiscriminate, factor-driven buying and selling that could generate exploitable price disconnects, whether growth or value stocks. Equity Portfolio Manager Dirk Enderlein summed up the opportunity best: “This type of extreme setup does not happen very often during one’s career and it usually offers an enormous opportunity for alpha generation for our clients.”

Value’s resurgence did not begin in January of this year. By many measures, value outperformed growth in 2021. However, that came after an unprecedented run of growth dominance throughout the 2010s, culminating in 2020, which saw “the largest outperformance by growth EVER in the data going all the way back to the beginning of the data series in 1927,” as Equity Portfolio Manager Sean Kammann noted. Kammann applied the Fama French asset pricing model to quantify the dynamic. His analysis is striking:

“What’s important to realize is how unusual 2020 and the decade before that was… From 1927 to 2020, value outperformed growth by 397 basis points annually on average. For the rolling 10-year periods from 1936 to 2020, value outperformed 91% or 85% of the time (depending on how you measure it). Perhaps even more interestingly, almost all of those rolling 10-year periods where growth outperformed were 10-year periods that ended in the last decade. What we have just witnessed, and what many investors globally likely anchor to, is extraordinarily unusual.”

Undoubtedly, fundamentals have played a paramount role in growth’s anomalous run. The digital revolution has enabled business models with unprecedented efficiency and scalability. High-growth software firms have merited a market premium, and in many ways still do because of their strong business models and durable growth profile. However, the pandemic has ushered in economic change and high-growth software valuations became stretched in 2020. And, as Research Associate Colleen Chung noted, the gap between software growth and growth in other parts of the economy has narrowed as the rest of the economy has recovered, instigating the closure of the extreme valuation gap between value and growth.

“Historically, software’s price-to-earnings ratio relative to the S&P 500 has tracked the “growth gap” or the difference between the expected revenue growth of software companies and the expected growth of the market. In 2020, the growth gap between software and the market was as high as it had been in the last 20 years… Today, though software growth remains strong, economic recovery (and inflation) in other sectors is causing a rebound in overall market growth which is shrinking the growth gap. The growth gap is now only roughly 1%, which is as low as it’s been since 2011. In 2022, that gap should be a bit wider again and more in line with the historical average. At the same time, valuations are still well above average levels.”

Figure 2
value versus growth expect volatility fig2

Even today, roughly 75% of “value investors” remain underweight value, as Equity Portfolio Manager Andrew Corry noted recently. Meanwhile, hedge fund value exposure appears “a net short” even after recent value surge, as Gordy Lawrence noted. And, according to Equity Portfolio Manager Nataliya Kofman, global managers remain historically exposed to US equities, with North America accounting for 71% of the MSCI World Index versus just over 50% a decade ago. 

It is clear the value rebound has more room to run. Nonetheless, assuming a smooth transition neglects how entrenched the growth bias likely remains. There is an entire generation of market participants — both institutional and retail — that has never invested during a value regime. Market machinery has transformed since the global financial crisis (GFC), with factor-based strategies and retail investors having unprecedented influence over market outcomes. Unseating their growth bias will likely require consistent and overwhelming evidence of value’s primacy. And that’s unlikely to come given today’s turbulent economic environment.

Many value stocks have been neglected to extremes. Many growth companies have a clear path to validating lofty valuations. From sustainability to artificial intelligence and automation to supply-chain reshoring, there are powerful structural trends at play that could determine global winners and losers regardless of their factor classification. 

Time and again over the past year, we have quoted Equity Portfolio Manager Mark Mandel: “It would make a lot of sense that the GFC ushered in one regime, and COVID ushered in the next.” A resumption of value’s leadership could be a multiyear trend resulting from that investment regime change. For the time being, however, we expect volatility, more than value dominance, to define markets. Doubling down on fundamentals is a path to exploiting price disconnects that result from that volatility.

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Authored by
trevor noren
Trevor Noren
Director Thematic Strategy
Boston

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