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As we discussed in our recent Investment Outlook, equity factor leadership defied conventional wisdom for much of 2020: Defensiveness didn’t defend in the drawdown and value didn’t lead during the recovery. Growth, on the other hand, was never behind cumulatively, even during the worst of the COVID-driven downturn.
These dynamics only accelerated in late 2020 and early 2021. We did see a deep-value rally during the fourth quarter of 2020, brought on in part by news that vaccines were on the way. But it’s common to see a strong reversal among such stocks once a crisis subsides (though these reversals tend to be hard to sustain because they’re largely about re-ratings of multiples rather than fundamentals). What is entirely uncommon is seeing the highest-growth stocks do well alongside them (macro drivers that benefit deep-value stocks tend to pressure speculative growth names).
We believe the continued outperformance and narrow leadership of growth is a result of speculative behavior and a belief that certain companies will gain market share and grow profits indefinitely, even as macro trends point to potential headwinds.
Quantifying excessive expectations in today’s market
We see these excessive expectations imbedded in equity valuations, as quantified by a Holt valuation metric (%future), which uses a discounted cash flow (DCF) framework to assess the percentage of a company’s current market value that’s attributable to future cash-flow generation from assets that don’t yet exist. We find this metric useful for thinking about “execution risk” reflected in valuations, and we can roll it up to a regional level. As shown in Figure 1, the number of US stocks with a %future reading greater than 90% (light-blue bars) is at an all-time high, surpassing the levels seen during the dot-com bubble of 1999 – 2000. (We find a similar result for global markets ex-US.)
Like today, the late 1990s were marked by a sense of euphoria about the potential of successful companies with new business models. Importantly though, it was not highly profitable growth stocks that finally burst the bubble in 2000. It was the collapse of the more speculative areas — companies burning through cash, with extreme growth expectations, high price-to-sales ratios, and “new era” assumptions to justify valuations.
At these heights, some stocks could have a long way to fall
Our research indicates that reaching a %future reading of 90% or more can be a dubious inflection point associated with significant underperformance. We looked at the full list of US stocks that reached this level over the past 25 years (412 observations) and found that they had an average forward 12-month relative return of nearly -25% (last bar in Figure 2).
Given that the US market has more of these names than at any point in the last 25 years, we see risks on the horizon. If the stocks deliver on their current valuations, they’ll be, at best, market-performers. At worst, we get a result like the one in Figure 2. For context, key characteristics of this group are very high growth rates (3x – 4x the market average) but with challenging fundamentals like price-to-sales ratios over 15x, negative implied discount rates, and below-market profitability.
What does this mean for growth and value allocations?
While the market has myopically focused on growth at any price, we think quality growth has been overlooked. Our core growth factor (which includes all high %future stocks) has attractive top-line growth and earnings momentum, but below-market profitability and a negative discount rate, implying it is expensive.1 Quality growth, on the other hand, is above market on the discount rate (implying there is value) and has above-market top-line growth and profitability, along with market-level earnings momentum. In short, we think quality growth is on sale. We hear growth-oriented portfolio managers echo these observations at the company level.
On the value front, tailwinds such as vaccine approvals and expectations of a strong economic recovery seem to have reduced the probability of some of the worst left-tail risks and make the recent value rally seem rational. But as with growth, the way one defines value matters a lot. While some “deep value” areas were driven to extreme valuation lows by the impact of pandemic shutdowns, they also face structural headwinds that were prevalent prior to COVID-19 (lack of mean reversion in profitability, zero-bound rates, sustainability issues). We think that once the macro risks priced into deep value have played themselves out, fundamentals will matter again. With that in mind, we find quality value more attractive than deep value.
Comparing our deep-value factor (low price-to-book) with our quality value factor (DCF value, an intrinsic value measure discussed in our recent paper), we find that while both are cheap (higher-than-market discount rates), the more fundamentally driven DCF value factor has market-like profitability and better growth and earnings momentum.1 So, yes, we think value looks attractive, but given the uncertain macro and policy environment, we lean toward areas where bottom-up fundamentals are strong.
We believe that both extreme growth and deep value have had their day and are now facing fairly strong headwinds. It’s possible to craft a narrative in which one of them continues to outperform, but we think it’s incredibly unlikely that they both do, as they each imply very different world views (e.g., lower rates vs higher rates, weak growth vs strong growth). We find the less extreme versions — quality growth and quality value — far more attractive at this point, given their fundamentals, and believe that if we have a reasonable recovery path, both can potentially do well for an extended period.
1Sources: Wellington Management, FactSet, HOLT. As of 31 December 2020. Proprietary risk factors developed by Wellington’s Fundamental Factor Team. The core growth factor combines predicted and trailing growth in sales and assets. The quality growth factor looks for companies with a growing asset base that generate positive economic profits. The low P/B factor identifies stocks with the lowest price-to-book ratios. DCF value uses a discounted cash flow model to identify the cheapest stocks in the universe. Additional information on this data is available upon request. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE.
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